About the Authors

Campbell R. McConnell earned his Ph.D. from the University of Iowa after receiving
degrees from Cornell College and the University of Illinois. He taught at the Uni-
versity of Nebraska-Lincoln from 1953 until his retirement in 1990. He is also co-
author of Contemporary Labor Economics, 5th ed. (McGraw-Hill) and has edited
readers for the principles and labour economics courses. He is a recipient of both the
University of Nebraska Distinguished Teaching Award and the James A. Lake Aca-
demic Freedom Award, and is past-president of the Midwest Economics Associa-
tion. Professor McConnell was awarded an honorary Doctor of Laws degree from
Cornell College in 1973 and received its Distinguished Achievement Award in 1994.
His primary areas of interest are labour economics and economic education. He has
an extensive collection of jazz recordings and enjoys reading jazz history.

Stanley L. Brue did his undergraduate work at Augustana College (SD) and received
his Ph.D. from the University of Nebraska-Lincoln. He teaches at Pacific Lutheran
University, where he has been honoured as a recipient of the Burlington Northern
Faculty Achievement Award. He has also received the national Leavey Award for
excellence in economic education. Professor Brue is past president and a current
member of the International Executive Board of Omicron Delta Epsilon Interna-
tional Economics Honorary. He is coauthor of Economic Scenes, 5th ed. (Prentice-
Hall) and Contemporary Labor Economics, 5th ed. (McGraw-Hill) and author of The
Evolution of Economic Thought, 5th ed. (HB/Dryden). For relaxation, he enjoys boat-
ing on Puget Sound and skiing trips with his family.

Thomas P. Barbiero received his Ph.D. from the University of Toronto after complet-
ing undergraduate studies at the same university. He has published papers on the
role of the agricultural sector in the industrial development of northern Italy in the
period 1861–1914. His research interest in the last few years has turned to economic
methodology and the application of economic theory to explain social phenomena.
Professor Barbiero spends part of his summer on the Amalfi Coast in Italy.
Preface
Welcome to the ninth edition of Microeconomics, North America’s best-selling eco-
nomics textbook. More than 7 million Canadian and U. S. students have now used
this book. It has been adapted into Australian, Italian, Russian, and Chinese edi-
tions, and translated into French, Spanish, and other languages.

What’s New and Improved?

We thoroughly revised, polished, and updated this edition. To use a software
analogy, this is version 9.0, not 8.1 or 8.2. The comments of reviewers and survey
correspondents provided encouragement, motivated improvements, and sparked
innovation.

Streamlined Presentations
A major revision goal was to streamline presentations, where possible, without com-
promising the thoroughness of our explanations. Our efforts resulted in a more effi-
cient organization and greater clarity. An example is Chapter 4, “An Overview of the
Market System and the Canadian Economy,” which is both shorter and better
organized than before. You will find similar kinds of improvements throughout the
ninth edition. Where needed, of course, the “extra sentence of explanation” remains
a distinguishing characteristic of Microeconomics. Brevity at the expense of clarity is
a false economy.

Improved Content
The Ten Key Concepts, which appeared in the eighth edition, have been reinforced
with margin icons when they are discussed later in the text. This serves to integrate
the key concepts throughout the text. We have made a number of micro discussions
less daunting and more interesting by changing abstract, axiomatic examples (such
as X and Y) to concrete examples familiar to students. Also, in keeping with our
goal of streamlining discussions, we have consolidated and deleted selected content
that was either peripheral to the discussion or was covered in further detail in later
chapters.
Instructors rarely assign all five micro application chapters (regulation and anti-
combines, agriculture, income inequality and poverty, and labour market issues),
but they appreciate the option to select two or three. We gave these chapters partic-
ular attention, revising and updating throughout. For example, Chapter 13 on com-
petition and government regulation is consolidated and now ends with a new Last
Word on the Microsoft case. Chapter 20 on agriculture reflects the recent decline in
the prices of some farm products. The discussion of income inequality in Chapter
17 is reorganized for greater clarity and smoother flow.
xvi Preface

Other New Topics and Revised Discussions

Along with the improvements just discussed, there are many other revisions. Here
are some examples.
● Part 1. Chapter 1: Changed terminology from material wants to economic
wants; revised discussion of economic methodology, focusing on the scientific
method. Chapter 2: Reorganized section on applications; greatly consolidated
section on economic systems. Chapter 3: Several new examples including
increased demand for coffee drinks, soy-enhanced hamburger as an inferior
good, increased supply of Internet service provision. Chapter 4: New chapter
title and introduction; revised section on competition to generalize beyond
pure competition; consolidation of the Five Fundamental Questions to Four,
with discussion explicitly organized around each; briefer chapter. Chapter 5:
New Figure 5-3 showing the types of international flows (trade flows, resource
flows, information and technology flows, and money flows); new discussion
of the euro; expanded discussion of the WTO.
● Part 2. Chapter 6: Title changed to reflect chapter content; added application
section on cross elasticity of demand; revamped section on government-
controlled prices. Chapter 7: Updated applications and extension section;
changed language from budget restraint to budget constraint. Chapter 8: Improved
explanation of explicit and implicit costs; added “learning-by-doing” to the list
of sources of economies of scale; new applications of economies of scale
(startup firms and newspapers). Chapter 9: Deleted the section on “Qualifica-
tions” to shorten the chapter and because we discuss each in detail in later
chapters. Chapter 10: New, updated examples throughout; substantially
revised section “Assessment and Policy Options.” Chapter 11: greatly short-
ened the discussion of cartels by focusing on only recent, rather than histori-
cal, OPEC actions; changed the identities of firms in the discussion of kinked
demand from A, B, C to hypothetically named firms. Chapter 12: Edited down
some long lists of examples and added new examples; added a new section on
consumer surplus and producer surplus. Chapter 13: Pared the chapter by
eliminating the discussion of industrial concentration and industrial policy;
updated examples on anti-combines, including the Microsoft case; revised sec-
tion on industrial regulation for clarity and relevance to today’s regulatory and
deregulatory climate; reorganized the discussion of social regulation.
● Part 3. Chapter 15: Transposed the graphs in Figure 15-3; revised discussion
of the minimum wage; new Figure 15-9 shows how wage differentials can arise
on either the demand or supply side of labour markets, and added a section
on immigration. Chapter 16: Made the discussion of the single-tax proposal an
application of the idea of economic rent. Chapter 17: Reorganized discussion of
income inequality and trends in income inequality; new discussion of the
inequality of wealth.
● Part 4. Chapter 18: Revised Table 18-2 on cost-benefit analysis; integrated the
discussion of specific antipollution policies within the analysis of negative
externalities; added a brief section on global warming; New Global Perspec-
tive 18-1 on carbon dioxide emissions. Chapter 19: Added recent Canadian tax
revenue data and a section on the 2000 federal tax reform. Chapter 20: Refo-
cused Table 20-1 from farm population to farm employment.
 preface xvii

Internet Math Notes

Although most students in the principles course have only modest math skills, a few
have taken advanced high school courses in mathematics. For the latter group, see-
ing the algebra and, in a few cases, the calculus behind the economics is highly
revealing and useful. For those students, we have included on our Web site a set of
math notes. Written by Professor Peterson, these notes are creative, concise and to
the point. They undoubtedly will enhance the educational experience for math-
minded students.

Distinguishing Features
This text embraces a number of distinguishing features.
● Comprehensive Explanations at an Appropriate Level. Microeconomics is
comprehensive, analytical, and challenging, yet fully accessible to a wide range
of students. Its thoroughness and accessibility enable instructors to select top-
ics for special classroom emphasis with confidence that students can read and
comprehend independently other assigned material in the book.
● Fundamentals of the Market System. Many economies throughout the world
are making difficult transition from planning to markets. Our detailed descrip-
tion of the institutions and operation of the market system in Chapter 4 is even
more relevant than before. We pay particular attention to property rights,
entrepreneurship, freedom of enterprise and choice, competition, and the
role of profits because these concepts are poorly understood by beginning
students.
● Early Integration of International Economics. We give the principles and
institutions of the global economy early treatment. Chapter 5 examines the
growth of world trade, the major participants in world trade, specialization
and comparative advantage, the foreign exchange market, tariffs and subsi-
dies, and various trade agreements. This strong introduction to international
economics permits “globalization” of later microeconomics discussions.
● Early and Extensive Treatment of Government. Government is an integral
component of modern capitalism. This book introduces the economic func-
tions of government early and accords them systematic treatment in Chapter
4. Chapter 18 examines government and market failure in further detail and
Chapter 19 looks at salient facets of public choice theory and taxation.
● Stress on the Theory of the Firm and Technological Advance. We have given
much attention to the theory of the firm and technological advance. These con-
cepts are difficult for most beginning students; too brief expositions usually
compound these difficulties by raising more questions than they answer. We
have also coupled analysis of the various market structures with a discussion
of the impact of each market arrangement on price, output levels, resource
allocation, and the rate of technological advance. And our Chapter 12 on the
microeconomics of technology is unique to principles books.
● Focus on Economic Issues. For many students, microeconomic issues are
where the action is. We sought to guide that action along logical lines through
the application of appropriate analytical tools.
xviii Preface

Flexible Organization and Content

Microeconomics reflects the challenge that specific topics and concepts will likely pose
for average students. For instance, the theory of the firm and micro output and price
determination are carefully treated. Here, simplicity is correlated with comprehen-
siveness, not brevity.
Our experience suggests that in treating each basic topic—elasticity of demand
and supply, theory of the firm, and international economics—it is desirable to couple
analysis with policy. Generally, we use a three-step development of analytical tools:
(1) verbal descriptions and illustrations; (2) numerical examples, and (3) graphical
presentation based on these numerical illustrations.
All these considerations caused us to organize the book into four parts: Part 1:
An Introduction to Economics and the Economy; Part 2: Microeconomics of Prod-
uct Markets; Part 3: Microeconomics of Resource Markets; and Part 4: Microeco-
nomics of Government and Public Policy.
Although instructors generally agree as to the content of principles of microeco-
nomics course, they often differ as to how to arrange the material. Microeconomics
provides considerable organizational flexibility. Previous users tell us they often
substantially rearrange chapters with little sacrifice of continuity. Some instructors
will prefer to intersperse the microeconomics of Parts 2 and 3 with the problems
chapters of Part 4. For example, Chapter 20 on agriculture may follow Chapter 9 on
pure competition.

Pedagogical Aids for Students

Microeconomics has always been student oriented. Economics is concerned with effi-
ciency—accomplishing goals using the best methods. Therefore, we offer the stu-
dent some brief introductory comments on how to improve their efficiency and
hence their grades.
● In This Chapter You Will Learn We set out the learning objectives at the start
of each chapter so the chapter’s main concepts can easily be recognized.

A
ccording to an old joke, if you teach a

parrot to say “Demand and supply,”

you have an economist. There is much

truth in this quip. The tools of demand and

supply can take us far in understanding both

IN THIS CHAPTER specific economic issues and how the entire

Y OU WILL LEARN:
economy works.
What markets are.
• With our circular flow model in Chapter 2,
What demand is and
we identified the participants in the product
what factors affect it.
•
market and resource market. We asserted
What supply is and
what factors affect it. that prices were determined by the “interac-
•
How demand and tion” between buyers and sellers in those
supply together determine
market equilibrium. markets. In this chapter we examine that

interaction in detail and explain how prices

 preface xix

● Web Links New to this edition are the addition of Web site references, a key
research tool directing students to Web sites that tie into the chapter material.
● Terminology A significant portion of any introductory course is terminology.
In this edition key terms are highlighted in bold type the first time they appear
in the text. Key terms are defined in the margin and a comprehensive list
appears at the end of each chapter. A glossary of definitions can also be found
at the end of the book and on the Web site.
● Ten Key Concepts Ten Key Concepts have been identified to help students
organize the main principles. The Ten Key Concepts are introduced in Chap-
ter 1 and are reinforced throughout the textbook with an icon.

TRADEOFFS AND OPPORTUNITY COSTS

Many current controversies illustrate the tradeoffs and opportunity costs indicated
Facing
Tradeoffs in movements along a particular production possibilities curve. (Any two categories
of “output” can be placed on the axes of production possibilities curves.) Should
scenic land be used for logging and mining or preserved as wilderness? If the land
is used for logging and mining, the opportunity cost is the forgone benefits of
wilderness. If the land is used for wilderness, the opportunity cost is the lost value
of the wood and minerals that society forgoes.
Should society devote more resources to the criminal justice system (police,
courts, and prisons) or to education (teachers, books, and schools)? If society
devotes more resources to the criminal justice system, other things equal, the oppor-
tunity cost is forgone improvements in education. If more resources are allocated to
education, the opportunity cost is the forgone benefits from an improved criminal
justice system.

● Data updates can be found on the Web site www.mcgrawhill.ca/college/

mcconnell9 for selected Tables and Figures.

TABLE 5-1 PRINCIPAL CANADIAN EXPORTS AND IMPORTS

OF GOODS, 2000
Exports % of Total Imports % of Total

Machinery and equipment 25 Machinery and equipment 34

Automotive products 23 Automotive products 21
Industrial goods and materials 15 Industrial goods and materials 19
Forestry products 10 Consumer goods 11
Energy products 13 Agricultural and fishing products 5
Agricultural and fishing products 7 Energy products 5
Source: Statistics Canada, www.statisticscanada.ca/english/Pgdb/Economy/International/gblec05.htm
Visit www.mcgrawhill.ca/college/mcconnell9 for data update.
xx Preface

● Key Graphs We have labelled graphs having special relevance as Key

Graphs. There is a quick quiz of four questions related to each Key Graph,
with answers provided at the bottom of the graph.

Key Graph FI G U R E 3 - 5 EQUILIBRIUM PRICE AND QUANTITY

P
The intersection of the downsloping $6
demand curve D and the upsloping S
supply curve S indicates the equi-
5 6000-bushel
librium price and quantity, here $3 surplus
and 7000 bushels of corn. The short-

Price (per bushel)

ages of corn at below-equilibrium
prices (for example, 7000 bushels 4
at $2), drive up price. These higher
prices increase the quantity sup-
3
plied and reduce the quantity
demanded until equilibrium is
achieved. The surpluses caused by
2
above-equilibrium prices (for exam-
ple, 6000 bushels at $4), push price 7000-bushel
down. As price drops, the quantity 1 shortage
demanded rises and the quantity D
supplied falls until equilibrium is
established. At the equilibrium Q
price and quantity, there are neither 0 2 4 6 7 8 10 12 14 16 18
shortages nor surpluses of corn. Bushels of corn (thousands per week)

Quick Quiz
1. Demand curve D is downsloping because:
a. producers offer less product for sale as the price of the product falls.
b. lower prices of a product create income and substitution effects, which lead
consumers to purchase more of it.
c. the larger the number of buyers in a market, the lower the product price.
d. price and quantity demanded are directly (positively) related.

● Interactive Graphs (Java Applets) Developed under the supervision of Nor-

ris Peterson of Pacific Lutheran University, this interactive feature depicts
major graphs and instructs students to shift the curves, observe the outcomes,
and derive relevant generalizations. For selected Key Graphs, Java Applets are
available on the McConnell Web site, www.mcgrawhill.ca/college/mcconnell9.
● Reviewing the chapter Important things should be said more than once. You will
find a Chapter Summary at the conclusion of every chapter as well as two or three
Quick Reviews within each chapter. These review statements will help you to
focus on the essential ideas of each chapter and also to study for exams.

The market system requires private ownership
of property, freedom of enterprise, freedom of
choice, and limited government.
The market system permits economic entities—
business, resource suppliers, and consumers—
to pursue and further their self-interest. It pre-
vents any single economic entity from dictating
the prices of products or resources.
The coordinating mechanism of the market sys-
tem is a system of markets and prices.
 preface xxi

● Global Perspective boxes Each nation functions increasingly in a global

economy. To gain appreciation of this wider economic environment, be sure to
take a look at the Global Perspectives features, which compare Canada to
other nations.

5.2

Exports of goods, 1999

Comparative exports (billions of dollars)
0 100 200 300 400 500 600
The United States, Germany,
United States
and Japan are the world’s
Germany
largest exporters. Canada
Japan
ranks seventh.
France
Britain
Canada
Italy
Netherlands
China
Belgium-Lux.
South Korea
Mexico
Taiwan
Singapore
Spain
Source: World Trade Organization, www.wto.org

● Appendix on graphs Being comfortable with graphical analysis and a few

related quantitative concepts will be a big advantage to students in under-
standing the principles of economics. The appendix to Chapter 1, which
reviews graphing, line slopes, and linear equations, should not be skipped.
● New Last Words About one fourth of the Last Words are new and others
have been revised and updated. The new topics are: the remarkable organiza-
tional ability of markets (Chapter 4—see page 95); the market for human
organs (Chapter 6—see page 150); the economics of criminal behaviour (Chap-
ter 7—see page 169); and the positive externalities of antitheft auto tracking
devices (Chapter 18—see page 479).

Through extension, the theory
of rational consumer behaviour
provides some useful insights on
criminal behaviour. Both the law-
ful consumer and the criminal try
to maximize their total utility (or
net benefit). For example, you
can remove a textbook from the
campus bookstore either by pur-
chasing it or stealing it. If you buy
the book, your action is legal; you
have fully compensated the book-
CRIMINAL BEHAVIOUR
Although economic analysis is not particularly relevant in
explaining some crimes of passions and violence (for example,
murder and rape), it does provide interesting insights on
such property crimes as robbery, burglary, and auto theft.
criminal has several facets. First, will choose to steal the book be-
there are the guilt costs, which cause the marginal benefit of $80
for many people are substantial. will exceed the marginal cost of
Such individuals would not steal $50. In contrast, someone having
from others even if there were no a guilt cost of, say, $40, will not
penalties for doing so; their moral steal the book. The marginal ben-
sense of right and wrong would efit of $80 will not be as great as
entail too great a guilt cost rela- the marginal cost of $90 (= $50 of
tive to the benefit from the stolen penalty cost + $40 of guilt cost).
good. Other types of costs in- This perspective on illegal be-
clude the direct costs of the crim- haviour has some interesting
inal activity (supplies and tools) implications. For example, other
xxii Preface

● Study Questions A comprehensive list of questions is located at the end

of each chapter. The old cliché that you “learn by doing” is very relevant to
economics. Use of these questions will enhance your understanding. We des-
ignate several of them as “Key Questions” and answer them in the Study
Guide.
● Internet Application Questions Students are presented with questions to
explore on the Internet relevant to the topic discussed in the chapter. From the
McConnell Web site, www.mcgrawhill.ca/college/mcconnell9, students will
find direct links to the Web sites included in these questions.

internet application questions

1. Check out the National Post 500 list of
the largest Canadian firms at <www.
nationalpostbusiness.com/datamining/top500/
top500.htm>. From the top ten profit list, select
three firms from three different industries
and discuss the likely sources of economies
of scale that underlie their large size.
2. Use the Yahoo search engine at <www.
yahoo.ca> to locate a company’s homepage
of your choice. Find and review the com-
pany’s income statement in its annual report
and classify the nonrevenue items as either
fixed or variable costs. Are all costs clearly
identifiable as either fixed or variable? What
item would be considered as accounting
profit? Would economic profit be higher or
lower than this accounting profit?

● Origin of the Idea These brief histories, which can be found on the Web site,
were written by Randy Grant of Linfield College and examine the origins of
major ideas identified in the book. Students will find it interesting to learn
about the person who first developed such ideas as opportunity costs, equi-
librium price, the multiplier, comparative advantage, and elasticity.

Supplements for Instructors

● The Instructor Online Learning Centre (www.mcgrawhill.ca/college/
mcconnell9) includes a password-protected Web site for instructors. The site
offers downloadable supplements and PageOut, the McGraw-Hill Ryerson
course Web site development centre.
● Instructor’s Resource Manual Thomas Barbiero, Ryerson University, has
revised and updated the Instructor’s Resource Manual. It includes chapter sum-
maries, listings of “what’s new” in each chapter, teaching tips and suggestions,
learning objectives, chapter outlines, data and visual aid sources with sugges-
tions for classroom use, and questions and problems.
● Microsoft® PowerPoint® Slide Powernotes Prepared by Judith Skuce,
Georgian College, this presentation system is found on the Instructor ’s
CD-ROM and on the Online Learning Centre. It offers visual presentations that
may be edited and manipulated to fit a particular course format. They have
been significantly revised for this edition and contain many animated graphs
and figures that have been imported from Excel.
● Test Bank 1 Prepared by Nargess Kayhani, Mount St. Vincent University, the
test bank includes more than 5400 questions and is available in printed format
and the electronic format can be found on the Instructor’s CD-ROM.
 preface xxiii

● Also available from the U.S. supplement list are:

● U.S. Test Bank II Written by William Walstad, this test bank contains
more than 5200 questions. All Test Bank II questions are categorized accord-
ing to level of difficulty: easy, moderate, or difficult.
● U.S. Test Bank III Also prepared by William Walstad, this test bank con-
tains “constructive response” testing to evaluate student understanding in
a manner different from conventional multiple-choice and true-false ques-
tions. Suggested answers to the essay and problem questions are included.
● Instructor’s Resource CD-ROM The CD-ROM contains everything the in-
structor needs for a multimedia lecture:
● Electronic Instructor’s Resource Manual Available in this edition is an
MS-WORD version of the Manual. Instructors can print out portions of the
manual’s contents, complete with their own additions and alterations, for
use as student handouts or in whatever ways they wish. This capability
includes printing out answers to the end-of-chapter questions.
● Microsoft® PowerPoint® Slide Presentation
● Computerized Test Bank The Brownstone Diploma Testing System offers
the test items for Microeconomics and Macroeconomics on CD-ROM.
● CBC Video Cases Accompanying the text is a series of video segments pre-
pared by Bruno Fullone and Morris Marshall, George Brown College. Four are
on microeconomics and four are on macroeconomics, drawn from CBC broad-
casts of Undercurrents, The National, Current Affairs, and Venture. These videos
have been chosen to aid students in relating real-world economic issues to the
text, and to illuminate key ideas and concepts presented in the text. A set of
instructor notes accompanies the segments and will be available at the Instruc-
tor Online Learning Centre. The video segments will be available in a VHS
format for use in class and through video-streaming on the Online Learning
Centre accessible by both instructors and students.
● PageOut Visit www.mhhe.com/pageout to create a Web page for your course
using our resources. PageOut is the McGraw-Hill Ryerson Web site development
centre. This Web page generation software is free to adopters and is designed to
help faculty create an online course, complete with assignments, quizzes, links
to relevant Web sites, lecture notes, and more in a matter of minutes.
● In addition, content cartridges are also available for course management sys-
TM
tems, such as WebCT and Blackboard. These platforms provide instructors
with more user friendly, flexible teaching tools. Please contact your local
McGraw-Hill Ryerson sales representative for additional information.
xxiv Preface

Supplements for Students

● Study Guide (ISBN#0-07-088670-9) Torben Andersen, Chairperson of Human-
ities and Social Sciences at Red Deer College, revised the ninth edition of the
Study Guide, which many students find indispensable. Each chapter contains
an introductory statement, a checklist of behavioural objectives, an outline, a
list of important terms, fill-in questions, problems and projects, objective ques-
tions, and discussion questions. The answers to both Macroeconomics’ and
Microeconomics’ end-of-chapter Key Questions appear at the end of the corre-
sponding Study Guide. The Guide comprises a superb “portable tutor” for the
principles student.
● DiscoverEcon (ISBN# 0-07-246135-7) Developed by Jerry Nelson at the Uni-
versity of Illinois-Champagne/Urbana, DiscoverEcon is available in a CD for-
mat or on the Web site for those who purchase a code. This menu-driven
software provides students with a complete tutorial linked to the text. Each
chapter features two essay questions, interactive graphs, a multiple-choice test
bank, and links to the glossary—all tied cohesively to the textbook.
● Online Learning Centre Here students will find self-grading Quiz Questions,
Internet Application Questions, Annotated Web links, and student projects or
cases (prepared by Morris Marshall of George Brown College)—all specific to
Microeconomics. For the math-minded student, there are Internet Math Notes,
which explore more deeply the mathematical detail of the concepts in the text.
For more information on the Online Learning Centre, see page xxvi.)
Acknowledgements
The ninth edition has benefited from a number of perceptive reviews, which were a
rich source of suggestions for this revision. Reviewers include

Ather Akbari, St. Mary’s University

Morris Altman, University of Saskatchewan
Sal AmirKhalkhali, St. Mary’s University
Bagala Biswal, Memorial University
Dale Box, University College of Fraser Valley
Beverly Cameron, University of Manitoba
Norm Cameron, University of Manitoba
Shernaz Choksi, Vanier College
Santo Dodaro, St. Francis Xavier University
Bruno Fullone, George Brown College
Carl Graham, Assiniboine Community College
Geraldine Joosse, Lethbridge Community College
Nargess Kayhani, Mount St. Vincent University
Morris Marshall, George Brown College
Charlene Richter, British Columbia Institute of Technology
Richard Schwindt, Simon Fraser University
Judith Skuce, Georgian College
Lee Swanson, Lakeland College
Harold Swierenga, Algonquin College

A special thank you must be given to David Cape, Ryerson University, for his vig-
ilant efforts as the technical reviewer for the text. His keen eye and attention to
detail has contributed greatly to the quality of the final product.
We also give special thanks to members of our U.S. team who have revised the
Fifteenth U.S. Edition of Economics.
We are greatly indebted to the many professionals at McGraw-Hill Ryerson—in
particular Lynn Fisher, Senior Sponsoring Editor; Ron Doleman, Economics Editor;
Maria Chu, Developmental Editor; Kelly Dickson, Manager, Editorial Services; and
Kelly Smyth, Marketing Manager —for their publishing and marketing expertise.
We thank Dawn Hunter and Lisa Berland for their thorough and sensitive edit-
ing and Jacques Cournoyer for his vivid Last Word illustrations. Dianna Little
developed the interior design and the colourful cover.
We also strongly acknowledge the McGraw-Hill Ryerson sales staff, which
greeted this edition with wholehearted enthusiasm.

Campbell R. McConnell
Stanley L. Brue
Thomas Barbiero
 ONE

The Nature
and Method
of Economics

W
ant is a growing giant whom the
coat of Have was never large
enough to cover.
Ralph Waldo Emerson
The Conduct of Life, 1860
IN THIS CHAPTER
Y OU WILL LEARN: People’s wants are many and diverse. Bio-
The Ten Key Concepts to logically, humans need only air, water, food,
retain for a lifetime.
clothing, and shelter. But in contemporary
•
The definition of economics. society we also seek the many goods and
• services associated with a comfortable stan-
About the economic
way of thinking. dard of living. Fortunately, society is blessed
• with productive resources—labour and man-
How economists
construct theories. agerial talent, tools and machinery, land and
• mineral deposits—that are used to produce
The distinction between
microeconomics and goods and services. This production satisfies
macroeconomics. many of our wants and takes place through
•
the organizational mechanism called the eco-
The pitfalls to objective
thinking. nomic system or, more simply, the economy.
 chapter one • the nature and method of economics 3

The blunt reality, however, is that our wants far exceed the productive capacity
of our limited resources. So the complete satisfaction of society’s wants is impos-
economics sible. This fact provides our definition of economics: it is the social science con-
The social science cerned with the efficient use of scarce resources to achieve the maximum satisfaction of
concerned with economic wants.
efficient use of
scarce resources
Numerous problems and issues arise from the challenge of using limited
to achieve the maxi- resources efficiently. Although it is tempting to plunge into them, that sort of analy-
mum satisfaction sis must wait. In this chapter, we need to discuss some important preliminaries.
of economic wants.

Ten Key Concepts to Retain for a Lifetime

Suppose you unexpectedly meet your introductory economics professor on the
street five or ten years after you complete this course. What will you be able to tell
her you retained from the course she taught? More than likely you will not be able
to remember very much. To help you retain the main ideas that economics has to
offer for many years after you complete it, we have come up with Ten Key Concepts
we believe are essential to understand the world around you and help you in your
chosen career. These key concepts will be reinforced throughout the textbook. When
a key concept is about to be discussed you will be alerted with an icon and the con-
cept description.
The 10 key concepts will simply be listed here; elaboration on each of the key con-
cepts will be found as we progress through the textbook. At the end of the course
you should review these 10 key concepts. They will help you organize and better
understand the materials you have studied. We have divided the 10 key concepts
into three categories: (a) those pertaining to the individual; (b) concepts that explain
the interaction among individuals; and (c) concepts that deal with the economy as
a whole and the standard of living.
Facing
Tradeoffs

The Individual
Opportunity
CONCEPT 1 (“Facing Tradeoffs”): Scarcity in relation to wants means you face
Costs tradeoffs; therefore you have to make choices.
CONCEPT 2 (“Opportunity Costs”): The cost of the choice you make is what you
Choosing give up for it, or the opportunity cost.
a Little More
or Less CONCEPT 3 (“Choosing a Little More or Less”): Choices are usually made at the
margin; we choose a “little” more or a “little” less of something.

The Influence CONCEPT 4 (“The Influence of Incentives”): The choices you make are influenced
of Incentives by incentives.

Specialization Interaction Among Individuals

and Trade
CONCEPT 5 (“Specialization and Trade”): Specialization and trade will improve
the well-being of all participants.
The CONCEPT 6 (“The Effectiveness of Markets”): Markets usually do a good job of
Effectiveness
of Markets coordinating trade among individuals, groups, and nations.
CONCEPT 7 (“The Role of Governments”): Governments can occasionally improve
The Role of the coordinating function of markets.
Governments
4 Part One • An Introduction to Economics and the Economy

The Economy as a Whole and the Standard of Living

Production CONCEPT 8 (“Production and the Standard of Living”): The standard of living of
and the
Standard of
the average person in a particular country is dependent on its production of goods
Living and services. A rise in the standard of living requires a rise in the output of goods
and services.
CONCEPT 9 (“Money and Inflation”): If the monetary authorities of a country annu-
Money and
Inflation ally print money in excess of the growth of output of goods and services it will even-
tually lead to inflation.

Inflation-
CONCEPT 10 (“Inflation-Unemployment Tradeoff”): In the short run, society faces
Unemployment a short-run tradeoff between inflation and its level of unemployment.
Tradeoff
These concepts will be elaborated on throughout this textbook. Be sure to be on
the lookout for the icon that alerts you that one of these concepts is being discussed.
We now turn to our first topic, the economic way of thinking.

The Economic Perspective

Close your eyes for a minute and pretend you are in paradise, a place where you can
have anything you want whenever you desire it. On a particular day you may
decide you want a new pair of jeans, a new portable computer, a cellular phone,
tickets to see ‘N Sync, and a new red Ferrari sports car to cruise around in. Your
friends may have a completely different list of wants, but all of their desires will also
be satisfied. Indeed, everyone’s desires are satisfied. The following day you can start
all over and make any request you have, and they will all be fulfilled. And so it will
continue forever. Your body will never get old or sick, you will have all the friends
and love you want, etc., etc.
Of course, paradise may be waiting for us in the afterlife, but in this world our
wants greatly outstrip our ability to satisfy them. Anytime there is a situation in
which wants are greater than the resources to meet those desires, we have an eco-
nomic problem. It is this reality that gives economists their unique perspective. This
economic economic perspective or economic way of thinking has several critical and closely
perspective interrelated features.
A viewpoint that
envisions individu-
als and institutions Scarcity and Choice
making rational
decisions by com- From our definition of economics, it is easy to see why economists view the world
paring the marginal through the lens of scarcity. Since human and property resources are scarce (lim-
benefits and mar- ited), it follows that the goods and services we produce must also be limited.
ginal costs associ- Scarcity limits our options and necessitates that we make choices. Because we “can’t
ated with their have it all,” we must decide what we will have, and what we must forgo.
actions.
Limited resources have given economics its core: the idea that “there is no free
lunch.” You may get treated to lunch, making it “free” to you, but there is a cost to
Opportunity
someone—ultimately to society. Scarce inputs of land, equipment, farm labour, the
Costs labour of cooks and waiters, and managerial talent are required. Because these
resources could be used in other production activities, they and the other goods and
services they could have produced are sacrificed in making the lunch available.
Economists call these sacrifices opportunity costs. To get more of one thing, you forgo
the opportunity of getting something else. So, the cost of that which you get is the
value of that which is sacrificed to obtain it. We will say much more about oppor-
tunity costs in Chapter 2.
 chapter one • the nature and method of economics 5

Rational Behaviour
Economics is grounded on the assumption of “rational self-interest.” Individuals
pursue actions that will allow them to achieve their greatest satisfaction. Rational
behaviour implies that individuals will make different choices under different cir-
cumstances. For example, Jones may decide to buy Coca-Cola in bulk at a ware-
house store rather than at a convenience store where it is much more expensive.
That will leave him with extra money to buy something else that provides satisfac-
tion. Yet, while driving home from work, he may stop at the convenience store to
buy a single can of Coca-Cola.
Rational self-interest also implies that individuals will make different choices. High
school graduate Alvarez may decide to attend college or university to major in busi-
ness. Baker may opt to take a job at a warehouse and buy a new car. Chin may accept
a signing bonus and join the Armed Forces. All three choices reflect the pursuit of self-
interest and are rational, but they are based on different preferences and circumstances.
Of course, rational decisions may change as costs and benefits change. Jones may
switch to Pepsi when it is on sale. And, after taking a few business courses, Alvarez
may decide to change her major to social work.
Rational self-interest is not the same as selfishness. People make personal sacri-
fices to help family members or friends, and they contribute to charities because
they derive pleasure from doing so. Parents help pay for their children’s education
for the same reason. These self-interested, but unselfish, acts help maximize the
givers’ satisfaction as much as any personal purchase of goods or services. Self-
interest behaviour is simply behaviour that enables a person to achieve personal sat-
isfaction, however that may be derived.

Marginal Analysis: Benefits and Costs

marginal The economic perspective focuses largely on marginal analysis—comparisons of
analysis The marginal benefits and marginal costs. (Used this way, “marginal” means “extra,”
comparison or mar- “additional,” or “a change in.”) Most choices or decisions involve changes in the sta-
ginal (“extra” or
“additional”) bene- tus quo (the existing state of affairs). Should you attend school for another year or
fits and marginal not? Should you study an extra hour for an exam? Should you add fries to your fast-
costs, usually for food order? Similarly, should a business expand or reduce its output? Should gov-
decision making. ernment increase or decrease health care funding?
Each option involves marginal benefits and, because of scarce resources, marginal
Choosing costs. In making choices rationally, the decision maker must compare those two
a Little More
or Less amounts. Example: You and your fiancé are shopping for an engagement ring.
Should you buy a 1⁄4 -carat diamond, a 1⁄2 -carat diamond, a 3⁄4 -carat diamond, or a
larger one? The marginal cost of the larger diamond is the added expense beyond
the smaller diamond. The marginal benefit is the greater lifetime pleasure (utility)
from the larger stone. If the marginal benefit of the larger diamond exceeds its mar-
ginal cost, you should buy the larger stone. But if the marginal cost is more than the
marginal benefit, you should buy the smaller diamond instead.
In a world of scarcity, the decision to obtain the marginal benefit associated with
some specific option always includes the marginal cost of forgoing something else.
The money spent on the larger diamond means forgoing something else. Again,
there is no free lunch!
One surprising implication of decisions based on marginal analysis is that there
can be too much of a good thing. Although certain goods and services seem inher-
ently desirable—education, health care, a pristine environment—we can in fact have
too much of them. “Too much” occurs when we keep obtaining them beyond the
6 Part One • An Introduction to Economics and the Economy

point where their marginal cost (the value of the forgone options) equals their mar-
ginal benefit. Then we are sacrificing alternative products that are more valuable at
the margin—the place where we consider the very last units of each. Society can have
too much health care and you can have too many fries. (Key Question 1)
This chapter’s Last Word provides an everyday application of the economic
perspective.

● Economics is concerned with obtaining maxi- ● The economic perspective stresses (a) resource
mum satisfaction through the efficient use of scarcity and the necessity of making choices, (b)
scarce resources. the assumption of rational behaviour, and (c) com-
parisons of marginal benefit and marginal cost.

Economic Methodology
Like the physical and life sciences, as well as other social science, economics relies
scientific on the scientific method. It consists of a number of elements:
method The
systematic pursuit ● The observation of facts (real world data);
of knowledge
through the formu-
● Based on those facts, the formulation of possible explanations of cause and
lation of a problem, effect (hypotheses).
collection of data,
and the formulation
● The testing of these explanations by comparing the outcomes of specific events
and testing of to the outcomes predicted by the hypotheses.
hypotheses.
● The acceptance, rejection, or modification of the hypotheses, based on these
comparisons.
● The continued testing of the hypotheses against the facts. As favourable results
accumulate, the hypotheses evolve into a theory, sometimes referred to as a model.
A very well-tested and widely accepted theory is referred to as a law or principle.
Laws, principles, and models enable the economist, like the natural scientist, to
understand and explain economic phenomena and to predict the various outcomes
of particular actions. But as we will soon see, economic laws and principles are usu-
ally less certain than the laws of physics or chemistry.

Deriving Theories
Economists develop models of the behaviour of individuals (consumers, workers)
and institutions (business, government) engaged in the production, exchange, and
consumption of goods and services. They start by gathering facts about economic
activity and economic outcomes. Because the world is cluttered with innumerable
interrelated facts, economists, like all scientists, must select the useful information.
They must determine which facts are relevant to the problem under consideration.
But even when this sorting process is complete, the relevant information may at first
seem random and unrelated.
The economist draws on the facts to establish cause–effect hypotheses about eco-
nomic behaviour. Then the hypotheses are tested against real world observation and
 chapter one • the nature and method of economics 7

FIGURE 1-1 THE RELATIONSHIP BETWEEN FACTS, THEORIES,

AND POLICIES IN ECONOMICS
Theoretical econom-
ics involves estab-
lishing economic POLICY ECONOMICS
theories by gathering,
systematically
arranging, and gen-
eralizing from facts.
Economic theories
are tested for validity
against facts. Econo-
mists use these
theories—the most
reliable of which are
called laws or princi- THEORETICAL ECONOMICS
ples—to explain and
analyze the economy. Theories
Policy economics
entails using the eco-
nomic laws and prin-
ciples to formulate
economic policies.

Facts

data. Through this process, the economist tries to discover hypotheses that rise to
the level of theories and principles (or laws)—well-tested and widely accepted gen-
eralizations about how individuals and institutions behave. The process of deriving
theoretical theories and principles is called theoretical economics (see the lower box in Figure
economics 1-1). The role of economic theorizing is to systematically arrange facts, interpret them, and
The process of generalize from them. Theories and principles bring order and meaning to facts by
deriving and apply-
ing economic theo-
arranging them in cause-and-effect order.
ries and principles. Observe that the arrow from “theories” to “facts” in Figure 1-1 moves in both
directions. Some understanding of factual, real-world evidence is required to for-
mulate meaningful hypotheses. And hypotheses are tested through gathering and
organizing factual data to see if the hypotheses can be verified.
principles Economic theories and principles are statements about economic behaviour that
Statements about enable prediction of the probable effects of certain actions. Good theories are those that do
economic behaviour a good job of explaining and predicting. They are supported by facts concerning
that enable predic-
tion of the probable
how individuals and institutions actually behave in producing, exchanging, and
effects of certain consuming goods and services. But these facts may change over time, so economists
actions. must continually check theories against the shifting economic environment.
Several other points relating to economic principles are important to know.
8 Part One • An Introduction to Economics and the Economy

TERMINOLOGY
Economists speak of “hypotheses,” “theories,” “models,” “laws,” and “principles.”
Some of these terms overlap but usually reflect the degree of confidence in the gen-
eralizations. A hypothesis needs initial testing; a theory has been tested but needs
more testing; a law or principle is a theory that has provided strong predicative
accuracy, over and over. The terminology economic laws and principles are useful,
even though they imply a degree of exactness and universal application that is rare
in any social science. The word theory is often used in economics even though many
people incorrectly believe theories have nothing to do with real-world applications.
In this book, custom and convenience will govern the use of “theory,” “law,”
“principle,” and “model.” Thus, we will use the term law of demand to describe the
relationship between the price of a product and the amount of it purchased, rather
than the theory or principle of demand, simply because this is the custom. We will
refer to the circular flow model, not the circular flow law, because it combines several
ideas into a single representation.

GENERALIZATIONS
generaliza- As we have already mentioned, economic theories, principles, and laws are gener-
tion Statement alizations relating to economic behaviour or to the economy itself. They are impre-
of the nature of the cise because economic facts are usually diverse; no two individuals or institutions
relation between
two or more sets act in exactly the same way. Economic principles are expressed as the tendencies of typi-
of facts. cal or average consumers, workers, or business firms. For example, when economists say
that consumer spending rises when personal income increases, they are well aware
that some households may save all of an increase in their incomes. But, on average,
and for the entire economy, spending goes up when income increases. Similarly,
economists claim that consumers buy more of a particular product when its price
falls. Some consumers may increase their purchases by a large amount, others by a
small amount, and a few not at all. This “price–quantity” principle, however, holds
for the typical consumer and for consumers as a group.

“OTHER-THINGS-EQUAL” ASSUMPTION
other- Like other scientists, economists use the ceteris paribus or other-things-equal
things- assumption to arrive at their generalizations. They assume that all other variables
equal except those under immediate consideration are held constant for a particular
assumption
The assumption analysis. For example, consider the relationship between the price of Pepsi and the
that factors other amount of it purchased. It helps to assume that, of all the factors that might influ-
than those being ence the amount of Pepsi purchased (for example, the price of Pepsi, the price of
considered are Coca-Cola, and consumer incomes and preferences), only the price of Pepsi varies.
held constant. We can then focus on the “price of Pepsi–purchases of Pepsi” relationship without
being confused by changes in other variables.
Natural scientists such as chemists or physicists can usually conduct controlled
experiments where “all other things” are in fact held constant (or virtually so). They
can test with great precision the assumed relationship between two variables. For
example, they might examine the height from which an object is dropped and the
length of time it takes to hit the ground. But economics is not a laboratory science.
Economists test their theories using real-world data, which are generated by the
actual operation of the economy. In this complex environment, “other things” do
change. Despite the development of sophisticated statistical techniques designed to
hold other things equal, control is less than perfect. As a result, economic theories
are less certain and less precise than those of laboratory sciences. That also means
 chapter one • the nature and method of economics 9

they are more open to debate than many scientific theories (for example, the law
of gravity.)

ABSTRACTIONS
Economic theories are abstractions—simplifications that omit irrelevant facts and cir-
cumstances. Economic models do not mirror the full complexity of the real world.
The very process of sorting out and analyzing facts involves simplification and
removal of clutter. Unfortunately, this “abstraction” leads some people to consider
economic theory impractical and unrealistic. That is simply nonsense! Economic
theories are practical precisely because they are abstractions. The full scope of eco-
nomic reality itself is too complex to be understood as a whole. Economists
abstract—that is, develop theories and build models—to give meaning to an other-
wise overwhelming and confusing maze of facts. Theorizing for this purpose is
highly practical.

GRAPHICAL EXPRESSION
Many of the economic models in this book are expressed graphically; the most
important are labelled Key Graphs. Be sure to read the appendix to this chapter as a
review of graphs.

Policy Economics
policy Applied economics, or policy economics is the application of theories and data to
economics formulate policies that aim to resolve a specific economic problem or further an eco-
The formulation of nomic goal. Economic theories are the foundation of economic policy, as shown in
courses of action to
bring about desired
the upper part of Figure 1-1. Economic policy normally is applied to problems after
economic outcomes they arise. However, if economic analysis can predict some undesirable event, such
or to prevent unde- as unemployment, inflation, or an increase in poverty, then it may be possible to
sired occurrences. avoid or moderate that event through economic policy. For example, you may read
in the newspaper that the Bank of Canada has reduced interest rates to increase
spending and prevent a recession.

www.bankofcanada.ca
FORMULATING ECONOMIC POLICY
Bank of Canada Here are the basic steps in policy-making:
● State the goal. The first step is to make a clear statement of the economic goal.
If we say that we want “full employment,” do we mean that everyone
between, say, 16 and 65 years of age should have a job? Or do we mean that
everyone who wants to work should have a job? Should we allow for some
unemployment caused by inevitable changes in the structure of industry and
workers voluntarily changing jobs? The goal must be specific.
● Determine the policy options. The next step is to formulate alternative poli-
cies designed to achieve the goal, and determine the possible effects of each
policy. This requires a detailed assessment of the economic impact, benefits,
costs, and political feasibility of the alternative policies. For example, to
achieve full employment, should government use fiscal policy (which involves
changing government spending and taxes), monetary policy (which entails
altering the supply of money), an education and training policy that enhances
worker employability, or a policy of wage subsidies to firms that hire disad-
vantaged workers?
10 Part One • An Introduction to Economics and the Economy

● Implement and evaluate the policy that was selected. After implementing the
policy, we need to evaluate how well it worked. Only through unbiased evalu-
ation can we improve on economic policy. Did a specific change in taxes or the
money supply alter the level of employment to the extent predicted? Did dereg-
ulation of a particular industry (for example, banking) yield the predicted ben-
eficial results? If not, why not? What were the harmful side effects, if any? How
might the policy be altered to make it work better? (Key Question 5)

ECONOMIC GOALS
If economic policies are designed to achieve specific economic goals, then we need
to recognize a number of goals that are widely accepted in Canada and many other
countries. They include:
● Economic growth Produce more and better goods and services, or, more sim-
ply, develop a higher standard of living.
● Full employment Provide suitable jobs for all citizens who are willing and
able to work.
● Economic efficiency Achieve the maximum fulfillment of wants using the
available productive resources.
● Price-level stability Avoid large upswings and downswings in the general
price level; that is, avoid inflation and deflation.
● Economic freedom Guarantee that businesses, workers, and consumers have
a high degree of freedom of choice in their economic activities.
● Equitable distribution of income Ensure that no group of citizens faces
poverty while most others enjoy abundance.
● Economic security Provide for those who are chronically ill, disabled, laid
off, aged, or otherwise unable to earn minimal levels of income.
● Balance of trade Seek a reasonable overall balance with the rest of the world
in international trade and financial transactions.
Although most of us might accept these goals as generally stated, we might also dis-
agree substantially on their specific meanings. What are “large” changes in the price
level? What is a “high degree” of economic freedom? What is an “equitable” distri-
bution of income? How can we measure precisely such abstract goals as “economic
freedom”? These objectives are often the subject of spirited public debate.
Also, some of these goals are complementary; when one is achieved, some other
one will also be realized. For example, achieving full employment means eliminat-
ing unemployment, which is a basic cause of inequitable income distribution. But
tradeoffs other goals may conflict or even be mutually exclusive. They may entail tradeoffs,
The sacrifice of meaning that to achieve one we must sacrifice another. For example, efforts to equal-
some or all of one ize the distribution of income may weaken incentives to work, invest, innovate, and
economic goal,
good, or service
take business risks, all of which promote economic growth. Taxing high-income
to achieve some people heavily and transferring the tax revenues to low-income people is one way
other goal, good, to equalize the distribution of income. But then the incentives to high-income indi-
or service. viduals may diminish because higher taxes reduce their rewards for working. Sim-
ilarly, low-income individuals may be less motivated to work when government
Facing
stands ready to subsidize them.
Tradeoffs When goals conflict, society must develop a system to prioritize the objectives it
seeks. If more economic freedom is accompanied by less economic security and
 chapter one • the nature and method of economics 11

more economic security allows less economic freedom, society must assess the
tradeoffs and decide on the optimal (best) balance between them.

● Economists use the scientific method to estab-
lish theories, laws, and principles. Economic
theories (laws, principles, or models) are gen-
eralizations relating to the economic behaviour
of individuals and institutions; good theories
are grounded in facts.
● Theoretical economics involves formulating
theories (or laws and principles) and using
them to understand and explain economic
behaviour and the economy; policy economics
involves using the theories to fix economic
problems or promote economic goals.
● Policy-making requires a clear statement of
goals, a thorough assessment of options, and
an unbiased evaluation of results.
● Some of society’s economic goals are comple-
mentary, while others conflict; where conflicts
exist, tradeoffs arise.

Macroeconomics and Microeconomics

Economists derive and apply principles about economic behaviour at two levels.

Macroeconomics
macro- Macroeconomics examines either the economy as a whole or its basic subdivisions
economics or aggregates such as the government, household, and business sectors. An aggre-
The part of econom- gate is a collection of specific economic units treated as if they were one unit. There-
ics concerned with
the economy as a
fore, we might lump together the millions of consumers in the Canadian economy
whole. and treat them as if they were one huge unit called “consumers.”
In using aggregates, macroeconomics seeks to obtain an overview, or general out-
aggregate line, of the structure of the economy and the relationships of its major aggregates.
A collection of Macroeconomics speaks of such economic measures as total output, total employ-
specific economic
units treated as if
ment, total income, aggregate expenditures, and the general level of prices in analyz-
they were one unit. ing various economic problems. Very little attention is given to specific units making
up the various aggregates. Macroeconomics examines the beach, not the sand,
rocks, and shells.

Microeconomics
micro- Microeconomics looks at specific economic units. At this level of analysis, we
economics observe the details of an economic unit, or very small segment of the economy,
The part of econom- under the figurative microscope. In microeconomics we talk of an individual indus-
ics concerned with
such individual
try, firm, or household. We measure the price of a specific product, the number of
units as industries, workers employed by a single firm, the revenue or income of a particular firm or
firms, and house- household, or the expenditures of a specific firm, government entity, or family. In
holds. microeconomics, we examine the sand, rocks, and shells, not the beach.
The macro-micro distinction does not mean that economics is so highly com-
partmentalized that every topic can be readily labelled as either macro or micro;
many topics and subdivisions of economics are rooted in both. Example: While the
problem of unemployment is usually treated as a macroeconomic topic (because
unemployment relates to aggregate spending), economists recognize that the deci-
sions made by individual workers in searching for jobs and the way specific product
12 Part One • An Introduction to Economics and the Economy

and labour markets operate are also critical in determining the unemployment rate.
(Key Question 7)

Positive and Normative Economics

Both macroeconomics and microeconomics involve facts, theories, and policies.
positive Each contains elements of positive economics and normative economics. Positive eco-
economics nomics focuses on facts and cause-and-effect relationships. Positive economics
The analysis of facts avoids value judgments, tries to establish scientific statements about economic
or data to establish
scientific generaliza-
behaviour, and deals with what the economy is actually like. Such factually based
tions about eco- analysis is critical to good policy analysis.
nomic behaviour. In contrast normative economics incorporates value judgments about what the
economy should be like. Normative economics looks at the desirability of certain
normative aspects of the economy. It underlies expressions of support for particular economic
economics policies.
The part of econom-
ics involving value Positive economics concerns what is, while normative economics embodies sub-
judgments about jective feelings about what ought to be. Here are some examples. Positive statement:
what the economy “The unemployment rate in several European nations is higher than that in Canada.”
should be like. Normative statement: “European nations ought to undertake policies to reduce their
unemployment rates.” A second positive statement: “Other things equal, if tuition is
substantially increased, college and university enrolment will fall.” Normative state-
ment: “College and university tuition should be lowered so that more students can
obtain an education.” Whenever words such as “ought” or “should” appear in a sen-
tence, there is a strong chance you are encountering a normative statement.
Most of the disagreement among economists involves normative, value-based
policy questions. Of course, there is often some disagreement about which theories
or models best represent the economy and its parts. But economists agree on a full
range of economic principles. Most economic controversy thus reflects differing
opinions or value judgments about what society should be like. (Key Question 8)

● Macroeconomics examines the economy as a
whole; microeconomics focuses on specific units
of the economy.
● Positive economics deals with factual state-
ments (“what is”); normative economics in-
volves value judgments (“what ought to be”).
Theoretical economics is “positive”; policy eco-
nomics is “normative.”

Pitfalls to Objective Thinking

Because they often affect us so personally, we often have difficulty thinking objec-
tively about economic issues. Here are some common pitfalls to avoid in success-
fully applying the economic perspective.

Biases
Most people bring a bundle of biases and preconceptions when thinking about eco-
nomic issues. For example, you might think that corporate profits are excessive or
 chapter one • the nature and method of economics 13

that lending money is always superior to borrowing money. Perhaps you believe
that government is necessarily less efficient than businesses or that more govern-
ment regulation is always better than less. Biases cloud thinking and interfere with
objective analysis. The novice economics student must be willing to shed biases and
preconceptions that are not supported by facts.

Loaded Terminology
The economic terminology used in newspapers and popular magazines is some-
times emotionally biased, or loaded. The writer or the interest group he or she rep-
resents may have a cause to promote or an axe to grind and may slant an article
accordingly. High profits may be labelled “obscene,” low wages may be called
“exploitive,” or self-interested behaviour may be “greed.” Government workers
may be referred to as “mindless bureaucrats,” and those favouring stronger gov-
ernment regulations may be called “socialists.” To objectively analyze economic
issues, you must be prepared to reject or discount such terminology.

Definitions
Some of the terms used in economics have precise technical definitions that are quite
different from those implied by their common usage. This is generally not a problem
if everyone understands these definitions and uses them consistently. For example,
investment to the average citizen means the purchase of stocks and bonds in security
markets, as when someone “invests” in Bell Canada stock or government bonds. But
to the economist, investment means the purchase of newly created real (physical) cap-
www.tse.com ital assets such as machinery and equipment or the construction of a new factory build-
Toronto Stock Exchange ing. It does not mean the purely financial transaction of swapping cash for securities.

Fallacy of Composition
Another pitfall in economic thinking is the assumption that what is true for one
individual or part of a whole is necessarily true for a group of individuals or the
fallacy of whole. This is a logical fallacy called the fallacy of composition; the assumption is
composition not correct. A statement that is valid for an individual or part is not necessarily valid
Incorrectly reason- for the larger group or whole.
ing that what is true
for the individual
Consider the following example from outside of economics. You are at a football
(or part) is neces- game and the home team makes an outstanding play. In the excitement, you leap to
sarily true for the your feet to get a better view. A valid statement: “If you, an individual, stand, your
group (or whole). view of the game is improved.” But is this also true for the group—for everyone
watching the play? Not necessarily. If everyone stands to watch the play, nobody—
including you—will probably have a better view than when all remain seated.
A second example comes from economics: An individual farmer who reaps a par-
ticularly large crop is likely to realize a sharp gain in income. But this statement can-
not be generalized to farmers as a group. The individual farmer’s large or “bumper”
crop will not noticeably influence (reduce) crop prices because each farmer pro-
duces a negligible fraction of the total farm output. But for all farmers as a group,
prices decline when total output increases. Thus, if all farmers reap bumper crops,
the total output of farm products will rise, depressing crop prices. If the price
declines are relatively large, total farm income might actually fall.
Recall our earlier distinction between macroeconomics and microeconomics: The
fallacy of composition reminds us that generalizations valid at one of these levels of analy-
sis may or may not be valid at the other.
14 Part One • An Introduction to Economics and the Economy

Causation Fallacies
Causation is sometimes difficult to identify in economics. Two important fallacies
often interfere with economic thinking.

POST HOC FALLACY

You must think very carefully before concluding that because event A precedes
post hoc, event B, A is the cause of B. This kind of faulty reasoning is known as the post hoc,
ergo ergo propter hoc or “after this, therefore because of this” fallacy.
propter Example: Suppose that early each spring the medicine man of a tribe performs a
hoc fallacy
Incorrectly reason- special dance. A week or so later the trees and grass turn green. Can we safely con-
ing that when one clude that event A, the medicine man’s dance, has caused event B, the landscape’s
event precedes turning green? Obviously not. The rooster crows before dawn, but that does not
another the first mean the rooster is responsible for the sunrise!
event must have A professional football team hires a new coach and the team’s record improves.
caused the second
event. Is the new coach the cause? Maybe. But perhaps the presence of more experienced
and talented players or an easier schedule is the true cause.

CORRELATION VERSUS CAUSATION

Do not confuse correlation, or connection, with causation. Correlation between two
events or two sets of data indicates only that they are associated in some systematic
and dependable way. For example, we may find that when variable X increases, Y
also increases. But this correlation does not necessarily mean that there is causa-
tion—that an increase in X is the cause of an increase in Y. The relationship could
be purely coincidental or dependent on some other factor, Z, not included in the
analysis.
Here is an example: Economists have found a positive correlation between edu-
cation and income. In general, people with more education earn higher incomes
than those with less education. Common sense suggests education is the cause and
higher incomes are the effect; more education implies a more knowledgeable and
productive worker, and such workers receive larger salaries.
But causation could also partly run the other way. People with higher incomes
could buy more education, just as they buy more furniture and steaks. Or is part of
the relationship explainable in still other ways? Are education and income corre-
lated because the characteristics required to succeed in education—ability and moti-
vation—are the same ones required to be a productive and highly paid worker? If
so, then people with those traits will probably obtain more education and earn
higher incomes. But greater education will not be the sole cause of the higher
income. (Key Question 9)

A Look Ahead
The ideas in this chapter will come into much sharper focus as you advance through
Part 1, where we develop specific economic principles and models. Specifically, in
Chapter 2 we will build a model of the production choices facing an economy. In
Chapter 3 we develop laws of demand and supply that will help you understand
how prices and quantities of goods and services are established in markets. In Chap-
ter 4 we combine all markets in the economy to see how the market system works.
And in Chapter 5 we examine a very important sector of the Canadian economy, the
international sector.

You enter a fast-food restaurant.
Do you immediately look to see
which line is the shortest? What
do you do when you are in the
middle of a long line and a new
serving station opens? Have you
ever gone to a fast-food restau-
rant, seen very long lines, and
then left? Have you ever become
annoyed when someone in front
of you in line placed an order
that took a long time to fill?
The economic perspective is
useful in analyzing the behaviour
of fast-food customers. These
consumers are at the restaurant
because they expect the mar-
ginal benefit from the food they
buy to match or exceed its mar-
ginal cost. When customers
enter the restaurant, they go to
the shortest line, believing that it
will minimize their time cost of
obtaining their food. They are
acting purposefully; time is lim-
ited and people prefer using it in
some way other than standing
in line.
If one fast-food line is tem-
porarily shorter than other lines,
some people will move toward
that line. These movers appar-
ently view the time saving asso-
ciated with the shorter line to
exceed the cost of moving from
their present line. The line
switching tends to equalize line
lengths. No further movement of
customers between lines occurs
once all lines are about equal.
Fast-food customers face an-
other cost-benefit decision when
a clerk opens a new station at
the counter. Should they move
chapter one • the nature and method of economics
FAST-FOOD LINES:
AN ECONOMIC PERSPECTIVE
How can the economic perspective help us understand
the behaviour of fast-food consumers?
to the new station or stay put?
Those who shift to the new line
decide that the time saving from
the move exceeds the extra cost
of physically moving. In so de-
ciding, customers must also
consider just how quickly they
can get to the new station com-
pared with others who may be
contemplating the same move.
(Those who hesitate in this situ-
ation are lost!)
Customers at the fast-food es-
tablishment do not have perfect
information when they select
lines. For example, they do not
first survey those in the lines to
determine what they are order-
ing before deciding which line
to enter. There are two reasons
for this. First, most customers
would tell them “It’s none of
your business,” and therefore
no information would be forth-
coming. Second, even if they
could obtain the information, the
amount of time necessary to get
it (a cost) would most certainly
exceed any time saving associ-
ated with finding the best line
(the benefit). Because informa-
tion is costly to obtain, fast-food
patrons select lines without per-
fect information. Thus, not all
decisions turn out as expected.
15
For example, you might enter a
short line and find someone in
front of you is ordering ham-
burgers and fries for 40 people
in the Greyhound bus parked
out back (and the employee is
a trainee)! Nevertheless, at the
time you made your decision,
you thought it was optimal.
Imperfect information also
explains why some people who
arrive at a fast-food restaurant
and observe long lines decide to
leave. These people conclude
that the marginal cost (monetary
plus time costs) of obtaining the
fast food is too large relative
to the marginal benefit. They
would not have come to the
restaurant in the first place had
they known the lines would be
so long. But getting that infor-
mation by, say, employing an
advance scout with a cellular
phone would cost more than the
perceived benefit.
Finally, customers must de-
cide what food to order when
they arrive at the counter. In
making their choices they again
compare marginal costs and
marginal benefits in attempting
to obtain the greatest personal
satisfaction or well-being for
their expenditure.
Economists believe that what
is true for the behaviour of cus-
tomers at fast-food restaurants is
true for economic behaviour in
general. Faced with an array of
choices, consumers, workers,
and businesses rationally com-
pare marginal costs and marginal
benefits in making decisions.
16 Part One • An Introduction to Economics and the Economy

chapter summary
1. Economics is the study of the efficient use of
scarce resources in the production of goods
and services to satisfy the maximum satisfac-
tion of economic wants.
2. The economic perspective includes three ele-
ments: scarcity and choice, rational behav-
iour, and marginalism. It sees individuals and
institutions making rational decisions based
on comparisons of marginal costs and mar-
ginal benefits.
3. Economists employ the scientific method in
which they form and test hypotheses of
cause-and-effect relationships to generate
theories, laws, and principles.
4. Generalizations stated by economists are
called principles, theories, laws, or models.
Good theories explain real-world relation-
ships and predict real-world outcomes.
5. Economic policy is designed to identify and
solve problems to the greatest extent possible
and at the least possible cost. This application
of economics is called policy economics.
6. Our society accepts certain shared economic
goals, including economic growth, full em-
ployment, economic efficiency, price-level
stability, economic freedom, equity in the dis-
tribution of income, economic security, and a
reasonable balance in international trade and
finance. Some of these goals are complemen-
tary; others entail tradeoffs.
7. Macroeconomics looks at the economy as
a whole or its major aggregates; microeco-
nomics examines specific economic units or
institutions.
8. Positive statements state facts (“what is”);
normative statements express value judg-
ments (“what ought to be”).
9. In studying economics we encounter such pit-
falls as biases and preconceptions, unfamiliar
or confusing terminology, the fallacy of com-
position, and the difficulty of establishing
clear cause–effect relationships.

terms and concepts

aggregate, p. 11
economic perspective, p. 4
economics, p. 3
fallacy of composition, p. 13
generalizations, p. 8
macroeconomics, p. 11
marginal analysis, p. 5
microeconomics, p. 11
normative economics, p. 12
“other-things-equal”
assumption, p. 8
policy economics, p. 9
positive economics, p. 12
post hoc, ergo procter hoc
fallacy, p. 14
principles, p. 7
scientific method, p. 6
theoretical economics, p. 7
tradeoffs, p. 10

study questions
1. KEY QUESTION Use the economic
perspective to explain why someone who is
normally a light eater at a standard restau-
rant may become a bit of a glutton at a buffet-
style restaurant that charges a single price
for all you can eat.
2. What is the scientific method and how does
it relate to theoretical economics? What is
the difference between a hypothesis and an
economic law or principle?
3. Why is it significant that economics is not a
laboratory science? What problems may be
involved in deriving and applying economic
principles?
4. Explain the following statements:
a. Good economic policy requires good
economic theory.
b. Generalization and abstraction are nearly
synonymous.
c. Facts serve to sort out good and bad
hypotheses.
d. The other things equal assumption helps
isolate key economic relationships.
5. KEY QUESTION Explain in detail the
interrelationships between economic facts,
theory, and policy. Critically evaluate this
statement: “The trouble with economic the-
ory is that it is not practical. It is detached
from the real world.”
 chapter one • the nature and method of economics
6. To what extent do you accept the eight eco-
nomic goals stated and described in this
chapter? What priorities do you assign to
them?
7. KEY QUESTION Indicate whether
each of the following statements applies to
microeconomics or macroeconomics:
a. The unemployment rate in Canada was
6.5 percent in January 2001.
b. The Alpo dog food plant in Bowser,
Alberta, laid off 15 workers last month.
c. An unexpected freeze in central Florida
reduced the citrus crop and caused the
price of oranges to rise.
d. Canadian output, adjusted for inflation,
grew by 4.7 percent in 2000.
e. Last week the Royal Bank lowered its
interest rate on business loans by one-
half of 1 percentage point.
f. The consumer price index rose by 2.7
percent in 2000.
8. KEY QUESTION Identify each of the
following as either a positive or a normative
statement:
a. The high temperature today was 30
degrees.
internet application questions
1. Three Economic Goals—Are They Being
Achieved? Three primary economic goals are
economic growth (an increase in real GDP), full
employment (less than 7 percent unemploy-
ment), and price-level stability (less than 2
percent as measured by the Consumer Price
Index—CPI). Statistics Canada www.statcan.ca/
english/Pgdb/Economy/econom.htm provides
links to Canadian economic data. Visit their
links for Output, Income, Expenditures (under
National accounts), Prices and Employment,
and Unemployment (Labour markets) to
assess whether these three goals are being
met in Canada.
17
b. It was too hot today.
c. Other things equal, higher interest rates
reduce the total amount of borrowing.
d. Interest rates are too high.
9. KEY QUESTION Explain and give an
example of (a) the fallacy of composition,
and (b) the “after this, therefore because of
this” fallacy. Why are cause-and-effect rela-
tionships difficult to isolate in economics?
10. Suppose studies show that students who
study more hours receive higher grades.
Does this relationship guarantee that any
particular student who studies longer will
get higher grades?
11. Studies indicate that married men on aver-
age earn more income than unmarried men
of the same age. Why must we be cautious
in concluding that marriage is the cause and
higher income is the effect?
12. (Last Word) Use the economic perspective to
explain the behaviour of the workers (rather
than the customers) observed at a fast-food
restaurant. Why are these workers there,
rather than, say, cruising around in their
cars? Why do they work so diligently? Why
do so many of them quit these jobs once
they have graduated high school?
2. Normative Economics—Canadian Politics.
Many economic policy statements made by
the Liberal Party www.liberal.ca, the Reform
Party www.reform.ca, the Progressive Con-
servative Party www.pcparty.ca, and the NDP
www.ndp.ca can be considered normative
rather than positive economic statements.
Visit their Web sites and compare and con-
trast their views on how to achieve economic
goals. How much of the disagreement is
based on positive statements and how much
on normative statements? Give an example of
loaded terminology from each site.
18 Part One • An Introduction to Economics and the Economy

Appendix to
Chapter 1

Graphs and Their Meaning

If you glance quickly through this text, you will find many graphs. Some seem sim-
ple, while others seem more complicated. All are important. They are included to
help you visualize and understand economic relationships. Physicists and chemists
sometimes illustrate their theories by building arrangements of multicoloured
wooden balls, representing protons, neutrons, and electrons, which are held in
proper relation to one another by wires or sticks. Economists most often use graphs
to illustrate their models. By understanding these “pictures,” you can more readily
comprehend economic relationships. Most of our principles or models explain rela-
tionships between just two sets of economic facts, which can be conveniently rep-
resented with two-dimensional graphs.

Construction of a Graph
horizontal A graph is a visual representation of the relationship between two variables. Table
axis The “left-
right” or “west- A1-1 is a hypothetical illustration showing the relationship between income and
east” axis on a consumption for the economy as a whole. Without even studying economics, we
graph or grid. would intuitively expect that people would buy more goods and services when
their incomes go up. Thus we are not surprised to find in Table A1-1 that total con-
vertical sumption in the economy increases as total income increases.
axis The “up-
down” or “north- The information in Table A1-1 is expressed graphically in Figure A1-1. Here is
south” axis on a how it is done: We want to show visually or graphically how consumption changes
graph or grid. as income changes. Since income is the determining factor, we represent it on the
horizontal axis of the graph, as is customary.
And because consumption depends on income,
TABLE A1-1 THE RELATIONSHIP we represent it on the vertical axis of the graph,
BETWEEN INCOME as is also customary. Actually, what we are
AND CONSUMPTION doing is representing the independent variable on
the horizontal axis and the dependent variable
Income Consumption
per week per week Point on the vertical axis.
Now we arrange the vertical and horizontal
$ 0 $ 50 a scales of the graph to reflect the ranges of values
100 100 b of consumption and income, and we mark the
200 150 c scales in convenient increments. As you can
see, the values marked on the scales cover all
300 200 d
the values in Table A1-1. The increments on
400 250 e
both scales are $100 for approximately each 1.25
centimetres.
 chapter one • the nature and method of economics 19

direct rela- Because the graph has two dimensions, each point within it represents an income
tionship The value and its associated consumption value. To find a point that represents one of the
(positive) relation-
ship between two
five income-consumption combinations in Table A1-1, we draw perpendiculars from
variables that change the appropriate values on the vertical and horizontal axes. For example, to plot point
in the same direc- c (the $200 income–$150 consumption point), perpendiculars are drawn up from the
tion, for example, horizontal (income) axis at $200 and across from the vertical (consumption) axis at
product price and $150. These perpendiculars intersect at point c, which represents this particular
quantity supplied.
income–consumption combination. You should verify that the other income–con-
inverse sumption combinations shown in Table A1-1 are properly located in Figure A1-1.
relationship Finally, by assuming that the same general relationship between income and con-
The (negative) rela-
tionship between two
sumption prevails for all other incomes, we draw a line or smooth curve to connect
variables that change these points. That line or curve represents the income–consumption relationship.
in opposite direc- If the graph is a straight line, as in Figure A1-1, we say the relationship is linear.
tions, for example,
product price and
quantity demanded. Direct and Inverse Relationships
independent The line in Figure A1-1 slopes upward to the right, so it depicts a direct relationship
variable The between income and consumption. By a direct relationship (or positive relation-
variable causing a
ship) we mean that two variables—in this case, consumption and income—change
change in some
other (dependent) in the same direction. An increase in consumption is associated with an increase in
variable. income; a decrease in consumption accompanies a decrease in income. When two
sets of data are positively or directly related, they always graph as an upsloping line,
dependent
variable A vari- as in Figure A1-1.
able that changes In contrast, two sets of data may be inversely related. Consider Table A1-2, which
as a consequence shows the relationship between the price of basketball tickets and game attendance
of a change in some at Informed University (IU). Here we have an inverse relationship (or negative rela-
other (independent)
tionship) because the two variables change in opposite directions. When ticket prices
variable; the “effect”
or outcome. decrease, attendance increases. When ticket prices increase, attendance decreases.
The six data points in Table A1-2 are plotted in
Figure A1-2. Observe that an inverse relation-
FIGURE A1-1 GRAPHING THE ship always graphs as a downsloping line.
DIRECT RELATIONSHIP BETWEEN
CONSUMPTION AND INCOME Dependent and Independent Variables
$400 Although it is not always easy, economists seek
to determine which variable is the “cause” and
which is the “effect.” Or, more formally, they
Consumption (C)

300 Consumption seek the independent variable and the depend-

C = 50 + .5Y e ent variable. The independent variable is the
d cause or source; it is the variable that changes
200
first. The dependent variable is the effect or
c
outcome; it is the variable that changes because
b of the change in the independent variable. As
100
a noted in our income–consumption example,
income generally is the independent variable
and consumption the dependent variable.
0 100 200 300 $400
Income causes consumption to be what it is
Income (Y )
rather than the other way around. Similarly,
Two sets of data that are positively or directly related, such as ticket prices (set in advance of the season)
consumption and income, graph as an upsloping line. determine attendance at IU basketball games;
attendance at games does not determine the
20 Part One • An Introduction to Economics and the Economy

ticket prices for those games. Ticket price is the

TABLE A1-2 THE RELATIONSHIP independent variable, and the quantity of tick-
BETWEEN TICKET ets purchased is the dependent variable.
PRICES AND You may recall from your high school courses
ATTENDANCE that mathematicians always put the independ-
ent variable (cause) on the horizontal axis and
Ticket Attendance,
price thousands Point the dependent variable (effect) on the vertical
axis. Economists are less tidy; their graphing of
$50 0 a independent and dependent variables is more
40 4 b arbitrary. Their conventional graphing of the
30 8 c income–consumption relationship is consistent
with mathematical presentation, but economists
20 12 d
put price and cost data on the vertical axis.
10 16 e Hence, economists graphing of IU’s ticket price-
0 20 f attendance data conflicts with normal mathe-
matical procedure.

Other Things Equal

Our simple two-variable graphs purposely ignore many other factors that might
affect the amount of consumption occurring at each income level or the number of
people who attend IU basketball games at each possible ticket price. When econo-
mists plot the relationship between any two
variables, they employ the ceteris paribus (other
FIGURE A1-2 GRAPHING THE things equal) assumption. Thus, in Figure A1-1
INVERSE RELATIONSHIP all factors other than income that might affect
BETWEEN TICKET PRICES AND the amount of consumption are presumed to be
GAME ATTENDANCE constant or unchanged. Similarly, in Figure A1-2
all factors other than ticket price that might
a influence attendance at IU basketball games are
$50 assumed constant. In reality, “other things” are
not equal; they often change, and when they do,
b the relationship represented in our two tables
40
P = 50 – 2.5Q and graphs will change. Specifically, the lines
Ticket price (P)

we have plotted would shift to new locations.

c
30 Consider a stock market “crash.” The dra-
matic drop in the value of stocks might cause
d people to feel less wealthy and therefore less
20 willing to consume at each level of income. The
result might be a downward shift of the con-
e Ticket sumption line. To see this, you should plot a
10
demand new consumption line in Figure A1-1, assuming
that consumption is, say, $20 less at each
f income level. Note that the relationship remains
0 4 8 12 16 20 direct; the line merely shifts downward to
Attendance in thousands (Q) reflect less consumption spending at each
Two sets of data that are negatively or inversely related, such income level.
as ticket price and the attendance at basketball games, graph Similarly, factors other than ticket prices
as a downsloping line. might affect IU game attendance. If IU loses
most of its games, attendance at IU games
 chapter one • the nature and method of economics 21

might be less at each ticket price. To see this, redraw Figure A1-2, assuming that
2000 fewer fans attend IU games at each ticket price. (Key Appendix Question 2)

Slope of a Line
slope of a Lines can be described in terms of their slopes and their intercepts. The slope of a
line The ratio of straight line is the ratio of the vertical change (the rise or drop) to the horizontal
the vertical change change (the run) between any two points of the line, or “rise” over “run.”
(the rise or fall) to
the horizontal
change (the run) POSITIVE SLOPE
between any two Between point b and point c in Figure A1-1 the rise or vertical change (the change in
points on a line. The consumption) is +$50 and the run or horizontal change (the change in income) is
slope of an upward
sloping line is posi-
+$100. Therefore:
tive, reflecting a vertical change +50 1
direct relationship Slope = ᎏᎏᎏ = ᎏ = ᎏ = .5
between two vari- horizontal change +100 2
ables; the slope of a
Note that our slope of 1⁄2 or .5 is positive because consumption and income change
downward sloping
line is negative, in the same direction; that is, consumption and income are directly or positively
reflecting an inverse related.
relationship between The slope of .5 tells us there will be a $1 increase in consumption for every $2
two variables. increase in income. Similarly, it indicates that for every $2 decrease in income there
will be a $1 decrease in consumption.

NEGATIVE SLOPE
Between any two of the identified points in Figure A1-2, say, point c and point d, the
vertical change is –10 (the drop) and the horizontal change is +4 (the run). Therefore:
vertical change –10
Slope = ᎏᎏᎏ = ᎏ = –2 1⁄2 = –2.5
horizontal change +4
This slope is negative because ticket price and attendance have an inverse or nega-
tive relationship.
Note that on the horizontal axis attendance is stated in thousands of people. So
the slope of –10/+4 or –2.5 means that lowering the price by $10 will increase atten-
dance by 4000 people. This is the same as saying that a $2.50 price reduction will
increase attendance by 1000 persons.

SLOPES AND MEASUREMENT UNITS

The slope of a line will be affected by the choice of units for either variable. If, in our
ticket price illustration, we had chosen to measure attendance in individual people,
our horizontal change would have been 4000 and the slope would have been
–10 –1
Slope = ᎏ = ᎏ = –.0025
+4000 +400
The slope depends on the way the relevant variables are measured.

SLOPES AND MARGINAL ANALYSIS

Recall that economics is largely concerned with changes from the status quo. The
concept of slope is important in economics because it reflects marginal changes—
those involving one more (or one less) unit. For example, in Figure A1-1 the .5 slope
22 Part One • An Introduction to Economics and the Economy

shows that $.50 of extra or marginal consumption is associated with each $1 change
in income. In this example, people collectively will consume $.50 of any $1 increase
in their incomes and reduce their consumption by $.50 for each $1 decline in income.

INFINITE AND ZERO SLOPES

Many variables are unrelated or independent of one another. For example, the quan-
tity of wristwatches purchased is not related to the price of bananas. In Figure
A1-3(a) we represent the price of bananas on the vertical axis and the quantity of
watches demanded on the horizontal axis. The graph of their relationship is the line
parallel to the vertical axis, indicating that the same quantity of watches is pur-
chased no matter what the price of bananas. The slope of such a line is infinite.
Similarly, aggregate consumption is completely unrelated to the nation’s divorce
rate. In Figure A1-3(b) we put consumption on the vertical axis and the divorce rate
on the horizontal axis. The line parallel to the horizontal axis represents this lack of
relatedness. This line has a slope of zero.

Vertical Intercept
A line can be located on a graph (without plotting points) if we know its slope and
vertical its vertical intercept. The vertical intercept of a line is the point where the line meets
intercept The the vertical axis. In Figure A1-1 the intercept is $50. This intercept means that if cur-
point at which a line rent income were zero, consumers would still spend $50. They might do this
meets the vertical
axis of a graph.
through borrowing or by selling some of their assets. Similarly, the $50 vertical inter-
cept in Figure A1-2 shows that at a $50 ticket price, IU’s basketball team would be
playing in an empty arena.

Equation of a Linear Relationship

If we know the vertical intercept and slope, we can describe a line succinctly in
equation form. In its general form, the equation of a straight line is
y = a + bx
where y = dependent variable
a = vertical intercept
b = slope of line
x = independent variable

FIGURE A1-3 INFINITE AND ZERO SLOPES

(a) A line parallel to the vertical
axis has an infinite slope. Here, Slope =
Price of bananas

purchases of watches remain the infinite

Consumption

same no matter what happens to

the price of bananas. (b) A line
parallel to the horizontal axis has a Slope = zero
slope of zero. Here, consumption
remains the same no matter what
happens to the divorce rate. In
both (a) and (b), the two variables
are totally unrelated to one
another. 0 Purchases of watches 0 Divorce rate
(a) (b)
 chapter one • the nature and method of economics 23

For our income-consumption example, if C represents consumption (the dependent

variable) and Y represents income (the independent variable), we can write C = a +
bY. By substituting the known values of the intercept and the slope, we get
C = 50 + .5Y
This equation also allows us to determine the amount of consumption C at any spe-
cific level of income. You should use it to confirm that at the $250 income level, con-
sumption is $175.
When economists reverse mathematical convention by putting the independent
variable on the vertical axis and the dependent variable on the horizontal axis, then
y stands for the independent variable, rather than the dependent variable in the
general form. We noted previously that this case is relevant for our IU ticket price-
attendance data. If P represents the ticket price (independent variable) and Q rep-
resents attendance (dependent variable), their relationship is given by
P = 50 – 2.5Q
where the vertical intercept is 50 and the negative slope is –2 1⁄2 or –2.5. Knowing
the value of P lets us solve for Q, our dependent variable. You should use this
equation to predict IU ticket sales when the ticket price is $15. (Key Appendix
Question 3)

Slope of a Nonlinear Curve

We now move from the simple world of linear relationships (straight lines) to the
more complex world of nonlinear relationships. The slope of a straight line is the
same at all its points. The slope of a line representing a nonlinear relationship
changes from one point to another. Such lines are referred to as curves. (It is also per-
missible to refer to a straight line as a “curve.”)
Consider the downsloping curve in Figure
FIGURE A1-4 DETERMINING THE A1-4. Its slope is negative throughout, but the
SLOPES OF CURVES curve flattens as we move down along it. Thus,
its slope constantly changes; the curve has a
different slope at each point.
To measure the slope at a specific point, we
a
20 draw a straight line tangent to the curve at that
point. A line is tangent at a point if it touches,
15 but does not intersect, the curve at that point.
Thus line aa is tangent to the curve in Figure
A1-4 at point A. The slope of the curve at that
10
A point is equal to the slope of the tangent line.
b Specifically, the total vertical change (drop) in
5 the tangent line aa is –20 and the total horizon-
B
tal change (run) is +5. Because the slope of the
a b tangent line aa is –20/+5, or –4, the slope of
0 5 10 15 20 the curve at point A is also –4.
The slope of a nonlinear curve changes from point to point on Line bb in Figure A1-4 is tangent to the curve
the curve. The slope at any point (say, B) can be determined by at point B. Following the same procedure, we
drawing a straight line that is tangent to that point (line bb) and find the slope at B to be –5/+15, or –1/3. Thus,
calculating the slope of that line. in this flatter part of the curve, the slope is less
negative. (Key Appendix Question 6)
24 Part One • An Introduction to Economics and the Economy
appendix summary
1. Graphs are a convenient and revealing way
to represent economic relationships.
2. Two variables are positively or directly re-
lated when their values change in the same
direction. The line (curve) representing two
directly related variables slopes upward.
3. Two variables are negatively or inversely
related when their values change in oppo-
site directions. The curve representing two
inversely related variables slopes down-
ward.
4. The value of the dependent variable (the
“effect”) is determined by the value of the
independent variable (the “cause”).
5. When the “other factors” that might affect
a two-variable relationship are allowed to
change, the graph of the relationship will
likely shift to a new location.
appendix terms and concepts
dependent variable, p. 19 independent variable, p. 19
direct relationship, p. 19 inverse relationship, p. 19
horizontal axis, p. 18 slope of a line, p. 21
appendix study questions
1. Briefly explain the use of graphs as a way to
represent economic relationships. What is
an inverse relationship? How does it graph?
What is a direct relationship? How does it
graph? Graph and explain the relationships
you would expect to find between (a) the
number of centimetres of rainfall per month
and the sale of umbrellas, (b) the amount of
tuition and the level of enrolment at a college
or university, and (c) the popularity of a music
artist and the price of her concert tickets.
In each case cite and explain how variables
other than those specifically mentioned might
upset the expected relationship. Is your graph
in part b, above, consistent with the fact that,
historically, enrolments and tuition have both
increased? If not, explain any difference.
2. KEY APPENDIX QUESTION Indi-
cate how each of the following might affect
the data shown in Table A1-2 and Figure A1-2
of this appendix:
a. IU’s athletic director schedules higher-
quality opponents.
6. The slope of a straight line is the ratio of
the vertical change to the horizontal change
between any two points. The slope of an
upsloping line is positive; the slope of a
downsloping line is negative.
7. The slope of a line or curve depends on the
units used in measuring the variables. It is
especially relevant for economics because it
measures marginal changes.
8. The slope of a horizontal line is zero; the
slope of a vertical line is infinite.
9. The vertical intercept and slope of a line
determine its location; they are used in ex-
pressing the line—and the relationship
between the two variables—as an equation.
10. The slope of a curve at any point is deter-
mined by calculating the slope of a straight-
line tangent to the curve at that point.
vertical axis, p. 18
vertical intercept, p. 22
b. An NBA team locates in the city where IU
also plays.
c. IU contracts to have all its home games
televised.
3. KEY APPENDIX QUESTION The
following table contains data on the relation-
ship between saving and income. Rearrange
these data into a meaningful order and graph
them on the accompanying grid. What is the
slope of the line? The vertical intercept? Inter-
pret the meaning of both the slope and the
intercept. Write the equation that represents
this line. What would you predict saving to be
at the $12,500 level of income?
Income Saving
(per year) (per year)
$15,000 $1,000
0 –500
10,000 500
5,000 0
20,000 1,500
 chapter one • the nature and method of economics 25

$1,500 your equation use the form i = a + bI, where i

Question 3 is the interest rate, a is the vertical intercept,
b is the slope of the line (which is negative),
1,000 and I is the level of investment. Comment on
the advantages and disadvantages of the ver-

Saving
bal, tabular, graphical, and equation forms of
500 description.
6. KEY APPENDIX QUESTION The
accompanying graph shows curve XX’ and
0
5 10 15 $20 tangents at points A, B, and C. Calculate the
Income (thousands) slope of the curve at these three points.
–500

50 (12, 50) a⬘ c⬘ (16, 50)

4. Construct a table from the data shown on the
graph below. Which is the dependent variable B
and which the independent variable? Sum- 40 b b⬘
marize the data in equation form.
30
A C
Question 4
20 (2, 10)
100
(26, 10)
Exam score (points)

10 a c
80 X X⬘
Question 6
60 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28

40 7. In the accompanying graph, is the slope of

curve AA’ positive or negative? Does the
slope increase or decrease as we move along
20
the curve from A to A’? Answer the same two
questions for curve BB’.
0 2 4 6 8 10
Study time (hours) Y

A'
5. Suppose that when the interest rate on loans
is 16 percent, businesses find it unprofitable B
to invest in machinery and equipment. How-
ever, when the interest rate is 14 percent,
$5 billion worth of investment is profitable. At
12 percent interest, a total of $10 billion of
investment is profitable. Similarly, total
investment increases by $5 billion for each
successive 2-percentage-point decline in the
interest rate. Describe the relevant relation- B'
ship between the interest rate and investment
in words, in a table, graphically, and as an A
equation. Put the interest rate on the vertical Question 7
axis and investment on the horizontal axis. In 0 X
 TWO

The
Economic
Problem:
Scarcity,
Wants, and
Choices
IN THIS CHAPTER
Y OU WILL LEARN:

Y
ou make decisions every day that cap-
The foundation of economics.
• ture the essence of economics. Sup-
The nature of economic efficiency.
• pose you have $40 and are deciding
How to achieve economic growth.
• how to spend it. Should you buy a new pair
The two general types
of economic systems of jeans? Two or three compact discs? A
society can choose to
coordinate production and ticket for a concert?
consumption decisions.
•
What the circular flow model is.
 chapter two • the economic problem: scarcity, wants, and choices 27

Should you forgo work while you are attending college or university and concen-
trate solely on your coursework and grades? Is that an option for you, given the ris-
ing cost of post-secondary education? If you decide to work, should it be full-time
or part-time? Should you work on campus at lower pay or off campus at higher
pay? What are the implications of your employment for your course grades?
Money and time are both scarce, and making decisions in the context of scarcity
always means there are costs. If you choose the jeans, the cost is the forgone CDs or
concert. If you work full-time, the cost might be greater stress, poorer performance
in your classes, or an extra year or two in school.
This chapter examines the fundamentals of economics—scarcity, choice, and costs.
We first examine the economic problem, focusing closely on wants and resources. Next,
we develop two economic models: (1) a production possibilities model that incorporates
and illustrates several key ideas, and (2) a simple circular flow model that identifies the
major groups of decision makers and major markets in the economy.

The Foundation of Economics

economic Two fundamental facts together constitute the economic problem and provide a
problem foundation for economics:
Choices are neces-
sary because soci- ● Society’s wants are virtually unlimited and insatiable.
ety’s material wants
for goods and serv- ● The resources for producing the goods and services to satisfy society’s wants
ices are unlimited are limited or scarce.
but the resources
available to satisfy All that follows depends directly on these two facts.
these wants are lim-
ited (scarce).
Unlimited Wants
What do we mean by “wants”? We mean, first, the desires of consumers to obtain
utility The sat- and use various goods and services that provide utility—that is, pleasure or satis-
isfaction or pleasure faction. These wants extend over a wide range of products, from necessities (food,
a consumer obtains shelter, and clothing) to luxuries (perfumes, yachts, race cars). Some wants—basic
from the consump-
tion of a good or a
food, clothing, and shelter—have biological roots. Other wants—for example, the
service. specific kinds of food, clothing, and shelter we seek—are rooted in the conventions
and customs of society.
Over time, wants change and tend to multiply, fuelled by new products. Not long
ago, we did not want personal computers, Internet service, digital recorders, lattes,
or pagers because they simply did not exist. Also, the satisfaction of certain wants
tends to trigger others: The acquisition of an Escort or Civic has been known to whet
the appetite for a Porsche or a Mercedes.
Services, as well as products, satisfy our wants. Car repair work, the removal of
an inflamed appendix, legal and accounting advice, and haircuts all satisfy human
wants. Actually, we buy many goods, such as automobiles and washing machines,
for the services they render. The differences between goods and services are often
smaller than they appear to be.
Businesses and units of government also strive to satisfy economic goals. Busi-
nesses want factories, machinery, trucks, warehouses, and phone systems to help
them to achieve their production goals. Government, reflecting the collective wants
of its citizens or goals of its own, seeks highways, schools, and military equipment.
All these wants are insatiable, or unlimited, meaning that our desires for goods and
services cannot be completely satisfied. Our desires for a particular good or service
28 Part One • An Introduction to Economics and the Economy

can be satisfied; over a short period of time we can surely get enough toothpaste or
pasta. And one appendectomy is plenty.
But goods in general are another story. We do not, and presumably cannot, get
enough. Suppose all members of society were asked to list the goods and services
they would buy if they had unlimited income. That list would probably never end.
In short, individuals and institutions have innumerable unfilled wants. The objec-
tive of all economic activity is to fulfill wants.

Scarce Resources
economic The second fundamental fact is that resources are limited or scarce. By economic
resources resources we mean all natural, human, and manufactured resources that go into the
The land, labour, production of goods and services. That includes all the factory and farm buildings
and entrepreneurial
ability that are used
and all the equipment, tools, and machinery used to produce manufactured goods
in the production of and agricultural products; all transportation and communication facilities; all types
goods and services. of labour; and land and mineral resources. Economists classify all these resources as
either property resources—land and raw materials and capital—or human resources—
land Natural labour and entrepreneurial ability.
resources (“free
gifts of nature”)
used to produce RESOURCE CATEGORIES
goods and services. Let’s look at four specific categories of resources.
capital Land Land means much more to the economist than it does to most people. To the
Human-made economist land includes all natural resources—all “gifts of nature”—that are used
resources (build- in the production process, such as arable land, forests, mineral and oil deposits, and
ings, machinery,
and equipment)
water resources.
used to produce Capital Capital (or capital goods or investment goods) includes all manufactured aids
goods and services.
used in producing consumer goods and services—that is, all tools, machinery, and
equipment, and factory, storage, transportation, and distribution facilities. The
investment process of producing and purchasing capital goods is known as investment.
Spending for the Capital goods differ from consumer goods in that consumer goods satisfy wants
production and directly, while capital goods do so indirectly by aiding the production of consumer
accumulation of
capital and addi-
goods. Note that the term “capital” as used by economists does not refer to money,
tions to inventories. but to real capital—tools, machinery, and other productive equipment. Money pro-
duces nothing; it is not an economic resource. So-called “money capital” or “finan-
cial capital” is simply a means for purchasing real capital.
labour The Labour Labour is a broad term for all the physical and mental talents of individu-
physical and mental als available and usable in producing goods and services. The services of a logger,
talents and efforts retail clerk, machinist, teacher, professional football player, and nuclear physicist all
of people that are
used to produce
fall under the general heading “labour.”
goods and services. Entrepreneurial Ability Finally, there is the special human resource, distinct from
entrepre- labour, that we label entrepreneurial ability. The entrepreneur performs several
neurial functions:
ability The ● The entrepreneur takes the initiative in combining the resources of land, capi-
human resources
that combine the tal, and labour to produce a good or a service. The entrepreneur is the driving
other resources to force behind production and the agent who combines the other resources in
produce a product, what is hoped will be a successful business venture.
make non-routine
decisions, innovate, ● The entrepreneur makes basic business-policy decisions—those non-routine deci-
and bear risks. sions that set the course of a business enterprise.
 chapter two • the economic problem: scarcity, wants, and choices 29

● The entrepreneur is an innovator—the one who commercializes new products,

new production techniques, or even new forms of business organization.
● The entrepreneur is a risk bearer. The entrepreneur in a market system has no
guarantee of profit. The reward for the entrepreneur’s time, efforts, and abili-
ties may be profits or losses. The entrepreneur risks not only his or her invested
funds but those of associates and stockholders as well.
Because these four resources—land, labour, capital, and entrepreneurial ability—
factors of are combined to produce goods and services, they are called the factors of production.
production
Economic resources: RESOURCE PAYMENTS
land, capital, labour,
and entrepreneurial The income received from supplying raw materials and capital equipment (the
ability. property resources) is called rental income and interest income, respectively. The
income accruing to those who supply labour is called wages, which includes salaries
and all wage and salary supplements such as bonuses, commissions, and royalties.
Entrepreneurial income is called profits, which may be negative—that is, losses.

RELATIVE SCARCITY
The four types of resources, or factors of production, or inputs, have one significant
characteristic in common: They are scarce or limited in supply. Our planet contains
only finite, and therefore limited, amounts of arable land, mineral deposits, capital
equipment, and labour. Their scarcity constrains productive activity and output. In
Canada, one of the most affluent nations, output per person was limited to roughly
$33,000 in 2000. In the poorest nations, annual output per person may be as low as
$300 or $400.

Economics: Getting the Most from

Available Resources
The economic problem is at the heart of the definition of economics stated in Chap-
ter 1: Economics is the social science concerned with the problem of using scarce resources
to attain the maximum fulfillment of society’s unlimited wants. Economics is concerned
with “doing the best with what we have.”
Economics is thus the social science that examines efficiency—the best use of
scarce resources. Society wants to use its limited resources efficiently; it desires to
produce as many goods and services as possible from its available resources,
thereby maximizing total satisfaction.

Full Employment: Using Available Resources

To realize the best use of scarce resources, a society must achieve both full employ-
full employ- ment and full production. By full employment we mean the use of all available
ment Use of all resources. No workers should be out of work if they are willing and able to work.
available resources Nor should capital equipment or arable land sit idle. But note that we say all avail-
to produce want-
satisfying goods
able resources should be employed. Each society has certain customs and practices
and services. that determine what resources are available for employment and what resources are
not. For example, in most countries legislation and custom provide that children and
the very aged should not be employed. Similarly, to maintain productivity, farm-
land should be allowed to lie fallow periodically. And we should conserve some
resources—fishing stocks and forest, for instance—for use by future generations.
30 Part One • An Introduction to Economics and the Economy

Full Production: Using Resources Efficiently

The employment of all available resources is not enough to achieve efficiency, how-
full ever. Full production must also be realized. By full production we mean that all
production employed resources should be used so that they provide the maximum possible sat-
Employment of
isfaction of our material wants. If we fail to realize full production, our resources are
available resources
so that the maxi- underemployed.
mum amount of Full production implies two kinds of efficiency—productive and allocative effi-
goods and services ciency. Productive efficiency is the production of any particular mix of goods and serv-
is produced. ices in the least costly way. When we produce, say, compact discs at the lowest
achievable unit cost, we are expending the smallest amount of resources to produce
productive
efficiency CDs and are therefore making available the largest amount of resources to produce
The production of other desired products. Suppose society has only $100 worth of resources available.
a good in the least If we can produce a CD for only $5 of those resources, then $95 will be available to
costly way. produce other goods. This is clearly better than producing the CD for $10 and hav-
ing only $90 of resources available for alternative uses.
allocative In contrast, allocative efficiency is the production of that particular mix of goods
efficiency and services most wanted by society. For example, society wants resources allocated to
The apportionment
compact discs and cassettes, not to 45 rpm records. We want personal computers
of resources among
firms and industries (PCs), not manual typewriters. Furthermore, we do not want to devote all our
to obtain the pro- resources to producing CDs and PCs; we want to assign some of them to producing
duction of the automobiles and office buildings. Allocative efficiency requires that an economy
products most produce the “right” mix of goods and services, with each item being produced at the
wanted by society
lowest possible unit cost. It means apportioning limited resources among firms and
(consumers).
industries in such a way that society obtains the combination of goods and services
it wants the most. (Key Question 5)

● People’s wants are virtually unlimited. ● Economic efficiency requires full employment
● Resources—land, capital, labour, and entrepre- and full production.
neurial ability needed to produce the goods and ● Full production requires both productive and
services to satisfy people’s wants—are scarce. allocative efficiency.
● Economics is concerned with the efficient allo-
cation of scarce resources to achieve the maxi-
mum fulfillment of society’s wants.

Production Possibilities Table

Because resources are scarce, a full-employment, full-production economy cannot
have an unlimited output of goods and services. Consequently, society must choose
which goods and services to produce and which to forgo. The necessity and conse-
quences of those choices can best be understood through a production possibilities
model. We examine the model first as a table, then as a graph.

ASSUMPTIONS
We begin our discussion of the production possibilities model with simplifying
assumptions:
 chapter two • the economic problem: scarcity, wants, and choices 31

● Full employment and productive efficiency The economy is employing all its
available resources (full employment) and is producing goods and services at
least cost (productive efficiency).
● Fixed resources The available supplies of the factors of production are fixed in
both quantity and quality. Nevertheless, they can be reallocated, within limits,
among different uses; for example, land can be used either for factory sites or
for food production.
● Fixed technology The state of technology does not change during our analy-
sis. This assumption and the previous one imply that we are looking at an
economy at a certain point in time or over a very short period of time.
● Two goods The economy is producing only two goods: pizzas and indus-
consumer trial robots. Pizzas symbolize consumer goods, products that satisfy our
goods Products wants directly; industrial robots symbolize capital goods, products that satisfy
and services that our wants indirectly by making possible more efficient production of con-
satisfy human
wants directly. sumer goods.

capital THE NEED FOR CHOICE

goods Goods Given our assumptions, we see that society must choose among alternatives. Fixed
that do not directly
satisfy human resources mean limited outputs of pizza and robots. And since all available
wants. resources are fully employed, to increase the production of robots we must shift
resources away from the production of pizzas. The reverse is also true: To increase
production the production of pizzas, we must shift resources away from the production of
possibilities robots. There is no such thing as a free pizza. This, recall, is the essence of the eco-
table A table nomic problem.
showing the differ-
ent combinations A production possibilities table lists the different combinations of two products
of two products that that can be produced with a specific set of resources (and with full employment and
can be produced productive efficiency). Table 2-1 is such a table for a pizza-robot economy; the data
with a specific set are, of course, hypothetical. At alternative A, this economy would be devoting all
of resources in a
full-employment,
its available resources to the production of robots (capital goods); at alternative E,
full-production all resources would go to pizza production (consumer goods). Those alternatives
economy. are unrealistic extremes; an economy typically produces both capital goods and
consumer goods, as in B,C, and D. As we move from alternative A to E, we increase
the production of pizza at the expense of robot
production.
TABLE 2-1 PRODUCTION Because consumer goods satisfy our wants
POSSIBILITIES directly, any movement toward E looks tempt-
OF PIZZAS AND ing. In producing more pizzas, society increases
ROBOTS WITH the current satisfaction of its wants. But there
FULL EMPLOYMENT is a cost: more pizzas mean fewer robots. This
AND PRODUCTIVE shift of resources to consumer goods catches
EFFICIENCY up with society over time as the stock of capi-
tal goods dwindles, with the result that some
PRODUCTION ALTERNATIVES potential for greater future production is lost.
Type of product A B C D E By moving toward alternative E, society
chooses “more now” at the expense of “much
Pizza (in hundred
more later.”
thousands) 0 1 2 3 4
By moving toward A, society chooses to
Robots (in thousands) 10 9 7 4 0
forgo current consumption, thereby freeing up
resources that can be used to increase the pro-
32 Part One • An Introduction to Economics and the Economy

duction of capital goods. By building up its stock of capital, society will have
greater future production and, therefore, greater future consumption. By moving
toward A, society is choosing “more later” at the cost of “less now.”
Generalization: At any point in time, an economy achieving full employment and pro-
ductive efficiency must sacrifice some of one good to obtain more of another good.

Production Possibilities Curve

The data presented in a production possibilities table can also be shown graphically.
We use a simple two-dimensional graph, arbitrarily representing the output of cap-
ital goods (here, robots) on the vertical axis and the output of consumer goods (here,
pizzas) on the horizontal axis, as shown in Figure 2-1 (Key Graph). Following the
production procedure given in the appendix to Chapter 1, we can graph a production possi-
possibilities bilities curve.
curve A curve Each point on the production possibilities curve represents some maximum out-
showing the differ-
ent combinations
put of the two products. The curve is a production frontier because it shows the limit
of goods and serv- of attainable outputs. To obtain the various combinations of pizza and robots on the
ices that can be production possibilities curve, society must achieve both full employment and pro-
produced in a ductive efficiency. Points lying inside (to the left of) the curve are also attainable, but
full-employment, they are inefficient and therefore are not as desirable as points on the curve. Points
full-production
economy where the
inside the curve imply that the economy could have more of both robots and pizzas
available supplies if it achieved full employment and productive efficiency. Points lying outside (to the
of resources and right of ) the production possibilities curve, like point W, would represent a greater
technology are output than the output at any point on the curve. Such points, however, are unat-
fixed. tainable with the current supplies of resources and technology.

Law of Increasing Opportunity Cost

Because resources are scarce relative to the virtually unlimited wants they can be
used to satisfy, people must choose among alternatives. More pizzas mean fewer
robots. The amount of other products that must be sacrificed to obtain one unit of a
opportunity specific good is called the opportunity cost of that good. In our case, the number of
cost The robots that must be given up to get another unit of pizza is the opportunity cost, or
amount of other simply the cost, of that unit of pizza.
products that must
be forgone or sacri-
In moving from alternative A to alternative B in Table 2-1, the cost of 1 additional
ficed to produce a unit of pizzas is 1 less unit of robots. But as we pursue the concept of cost through
unit of a product. the additional production possibilities—B to C, C to D, and D to E—an important
economic principle is revealed: The opportunity cost of each additional unit of pizza
Opportunity is greater than the opportunity cost of the preceding one. When we move from A to
Costs B, just 1 unit of robots is sacrificed for 1 more unit of pizza; but in going from B to
C we sacrifice 2 additional units of robots for 1 more unit of pizza; then 3 more of
robots for 1 more of pizza; and finally 4 for 1. Conversely, confirm that as we move
from E to A, the cost of an additional robot is 1⁄4, 1⁄3, 1⁄2, and 1 unit of pizza, respec-
tively, for the four successive moves.
Note two points about these opportunity costs:
● Here opportunity costs are being measured in real terms, that is, in actual
goods rather than in money terms.
● We are discussing marginal (meaning “extra”) opportunity costs, rather than
cumulative or total opportunity costs. For example, the marginal opportunity
cost of the third unit of pizza in Table 2-1 is 3 units of robots (= 7 – 4). But the
total opportunity cost of 3 units of pizza is 6 units of robots (= 1 unit of robots
 chapter two • the economic problem: scarcity, wants, and choices 33

Key Graph FIGURE 2-1 THE PRODUCTION POSSIBILITIES CURVE

Q
Each point on the production possibil-
ities curve represents some maximum A
10

Industrial robots (thousands)

combination of two products that can B
be produced if full employment and 9
full production are achieved. When Unattainable
8
operating on the curve, more robots C
means fewer pizzas, and vice versa. 7
W
Limited resources and a fixed tech- 6
nology make any combination of
robots and pizzas lying outside the 5
curve (such as at W) unattainable. D Attainable
4
Points inside the curve are attainable, Attain-
3 able,
but they indicate that full employment
but
and productive efficiency are not 2 inefficient
being realized.
1
E
Q
0 1 2 3 4 5 6 7 8
Pizzas (hundred thousands)

Quick Quiz
1. Production possibilities curve ABCDE is bowed out from the origin
(concave to the origin) because:
a. the marginal benefit of pizzas declines as more pizzas are consumed.
b. the curve gets steeper as we move from E to A.
c. it reflects the law of increasing opportunity costs.
d. resources are scarce.
2. The marginal opportunity cost of the second unit of pizzas is:
a. 2 units of robots.
b. 3 units of robots.
c. 7 units of robots.
d. 9 units of robots.
3. The total opportunity cost of 7 units of robots is:
a. 1 unit of pizza.
b. 2 units of pizza.
c. 3 units of pizza.
d. 4 units of pizza.
4. All points on this production possibilities curve necessarily represent:
a. allocative efficiency.
b. less than full use of resources.
c. unattainable levels of output.
d. productive efficiency.

Answers:
1. c; 2. a; 3. b; 4. d
34 Part One • An Introduction to Economics and the Economy

for the first unit of pizza plus 2 units of robots for the second unit of pizza plus
3 units of robots for the third unit of pizza).
law of Our example illustrates the law of increasing opportunity costs: The more of a
increasing product that is produced, the greater is its opportunity cost (“marginal” being
opportunity implied).
costs As the
production of a
good increases, the SHAPE OF THE CURVE
opportunity cost of The law of increasing opportunity costs is reflected in the shape of the production
producing an addi- possibilities curve: The curve is bowed out from the origin of the graph. Figure 2-1
tional unit rises.
shows that when the economy moves from A to E, successively larger amounts of
robots (1, 2, 3, and 4) are given up to acquire equal increments of pizza (1, 1, 1, and
1). This is shown in the slope of the production possibilities curve, which becomes
steeper as we move from A to E. A curve that gets steeper as we move down it is
“concave to the origin.”

ECONOMIC RATIONALE
What is the economic rationale for the law of increasing opportunity costs? Why
does the sacrifice of robots increase as we produce more pizzas? The answer is that
resources are not completely adaptable to alternative uses. Many resources are better at
producing one good than at producing others. Fertile farmland is highly suited to
producing the ingredients needed to make pizzas, while land rich in mineral
deposits is highly suited to producing the materials needed to make robots. As we
step up pizza production, resources that are less and less adaptable to making piz-
zas must be “pushed” into pizza production. If we start at A and move to B, we can
shift the resources whose productivity of pizzas is greatest in relation to their pro-
ductivity of robots. But as we move from B to C, C to D, and so on, resources highly
productive of pizzas become increasingly scarce. To get more pizzas, resources
whose productivity of robots is great in relation to their productivity of pizzas will
be needed. It will take more and more of such resources, and hence greater sacrifices
of robots, to achieve each increase of 1 unit in the production of pizzas. This lack of
perfect flexibility, or interchangeablility, on the part of resources is the cause of
increasing opportunity costs. (Key Question 6)

Allocative Efficiency Revisited

So far, we have assumed full employment and productive efficiency, both of which
are necessary to realize any point on an economy’s production possibilities curve. We
now turn to allocative efficiency, which requires that the economy produce at the
most valued, or optimal, point on the production possibilities curve. Of all the
attainable combinations of pizzas and robots on the curve in Figure 2-1, which is
best? That is, what specific quantities of resources should be allocated to pizzas and
what specific quantities to robots in order to maximize satisfaction?
Our discussion of the economic perspective in Chapter 1 puts us on the right track.
Recall that economic decisions centre on comparisons of marginal benefits and mar-
ginal costs. Any economic activity—for example, production or consumption—
should be expanded as long as marginal benefit exceeds marginal cost and should
be reduced if marginal cost exceeds marginal benefit. The optimal amount of the
activity occurs where MB = MC.
Consider pizzas. We already know from the law of increasing opportunity costs
that the marginal cost (MC) of additional units of pizzas will rise as more units are
 chapter two • the economic problem: scarcity, wants, and choices 35

produced. This can be shown by an upsloping MC curve, as in Figure 2-2. We also

know that we obtain extra or marginal benefits (MB) from additional units of piz-
zas. However, although material wants in the aggregate are insatiable, studies
reveal that the second unit of a particular product yields less additional benefit to a
person than the first. And a third provides even less MB than the second. So it is for
society as a whole. We therefore can portray the marginal benefits from pizzas with
a downsloping MB curve, as in Figure 2-2. Although total benefits rise when soci-
ety consumes more pizzas, marginal benefits decline.
The optimal quantity of pizza production is indicated by the intersection of the
MB and MC curves: 200,000 units in Figure 2-2. Why is this the optimal quantity? If
only 100,000 pizzas were produced, the marginal benefit of pizzas would exceed its
marginal cost. In money terms, MB might be $15, while MC is only $5. This suggests
that society would be underallocating resources to pizza production and that more
of it should be produced.
How do we know? Because society values an additional pizza as being worth $15,
while the alternative products that those resources could produce are worth only $5.
Society benefits whenever it can gain something valued $15 by forgoing something
valued only $5. Society would use its resources more efficiently by allocating more
resources to pizza. Each additional pizza up to 200,000 would provide such a gain,
indicating that allocative efficiency would be improved by that production. But when
MB = MC, the benefits of producing pizzas or alternative products with the available
resources are equal. Allocative efficiency is achieved where MB = MC.
The production of 300,000 pizzas would represent an overallocation of resources
to pizza production. Here the MC of pizzas is $15 and its MB is only $5. This means
that 1 unit of pizza is worth only $5 to society, while the alternative products that
those resources could otherwise produce are valued at $15. By producing 1 less unit,
society loses a pizza worth $5. But by reallocating the freed resources, it gains other
products worth $15. When society gains something worth $15 by forgoing some-

FIGURE 2-2 ALLOCATIVE EFFICIENCY: MB = MC

Allocative efficiency
requires the expan-
sion of a good’s out- $15 MC
put until its marginal
Marginal benefit and

benefit (MB) and

marginal cost (MC)
marginal cost

are equal. No 10
resources beyond
that point should get
allocated to the prod- MB  MC
uct. Here, allocative
efficiency occurs 5
when 200,000 pizzas
are produced. MB

0 1 2 3
Quantity of pizza
(hundred thousands)
36 Part One • An Introduction to Economics and the Economy

thing worth only $5, it is better off. In Figure 2-2, such net gains can be realized until
pizza production has been reduced to 200,000.
Generalization: Resources are being efficiently allocated to any product when the mar-
ginal benefit and marginal cost of its output are equal (MB = MC). Suppose that by apply-
ing the above analysis to robots, we find their optimal (MB = MC) output is 7000.
This would mean that alternative C on our production possibilities curve—200,000
pizzas and 7000 robots—would result in allocative efficiency for our hypothetical
economy. (Key Question 9)

● The production possibilities curve illustrates
four concepts: (a) scarcity of resources is implied
by the area of unattainable combinations of out-
put lying outside the production possibilities
curve; (b) choice among outputs is reflected in
the variety of attainable combinations of goods
lying along the curve; (c) opportunity cost is
illustrated by the downward slope of the curve;
(d) the law of increasing opportunity costs is
implied by the concavity of the curve.
● Full employment and productive efficiency must
be realized in order for the economy to operate
on its production possibilities curve.
● A comparison of marginal benefits and mar-
ginal costs is needed to determine allocative
efficiency—the best or optimal output mix on
the curve.

Unemployment, Growth, and The Future

Let’s now discard the first three assumptions underlying the production possibili-
ties curve and see what happens.

Unemployment and Productive Inefficiency

The first assumption was that our economy was achieving full employment and pro-
ductive efficiency. Our analysis and conclusions change if some resources are idle
(unemployment) or if least-cost production is not realized. The five alternatives in
Table 2-1 represent maximum outputs; they illustrate the combinations of robots and
pizzas that can be produced when the economy is operating at full capacity—with
full employment and productive efficiency. With unemployment or inefficient pro-
duction, the economy would produce less than each alternative shown in the table.
Graphically, we represent situations of unemployment or productive inefficiency
by points inside the original production possibilities curve (reproduced in Figure
2-3). Point U is one such point. Here the economy is falling short of the various max-
imum combinations of pizzas and robots represented by the points on the production
possibilities curve. The arrows in Figure 2-3 indicate three possible paths back to full-
employment and least-cost production. A move toward full employment and pro-
ductive efficiency would yield a greater output of one or both products.

A Growing Economy
Production When we drop the assumptions that the quantity and quality of resources and tech-
and the
Standard of nology are fixed, the production possibilities curve shifts positions—that is, the
Living potential maximum output of the economy changes.
 chapter two • the economic problem: scarcity, wants, and choices 37

FIGURE 2-3 UNEMPLOYMENT, PRODUCTIVE INEFFICIENCY, AND

THE PRODUCTION POSSIBILITIES CURVE
Any point inside the Q
production possibili-
ties curve, such as U, 10
represents unemploy-
ment or a failure to 9

Robots (thousands)
achieve productive 8
efficiency. The
arrows indicate 7
that, by realizing full 6
employment and pro-
5
ductive efficiency,
the economy could 4
operate on the curve. U
3
This means it could
produce more of one 2
or both products than 1
it is producing at
point U. Q
0 1 2 3 4 5 6 7 8
Pizzas (hundred thousands)

INCREASES IN RESOURCE SUPPLIES

Although resource supplies are fixed at any specific moment, they can and do
change over time. For example, a nation’s growing population will bring about
increases in the supplies of labour and entrepreneurial ability. Also, labour quality
usually improves over time. Historically, the economy’s stock of capital has
increased at a significant, though unsteady, rate. And although we are depleting
some of our energy and mineral resources, new sources are being discovered. The
development of irrigation programs, for example, adds to the supply of arable land.
The net result of these increased supplies of the factors of production is the ability
to produce more of both pizzas and robots. Thus, 20 years from now, the production
possibilities in Table 2-2 may supersede those
shown in Table 2-1. The greater abundance of
TABLE 2-2 PRODUCTION resources will result in a greater potential output
POSSIBILITIES of one or both products at each alternative. Soci-
OF PIZZA AND ety will have achieved economic growth in the
ROBOTS WITH form of an expanded potential output.
FULL EMPLOYMENT But such a favourable change in the produc-
AND PRODUCTIVE tion possibilities data does not guarantee that
EFFICIENCY the economy will actually operate at a point on
its new production possibilities curve. Some 15
PRODUCTION million jobs will give Canada full employment
ALTERNATIVES now, but 10 or 20 years from now its labour
Type of product A′ B′ C′ D′ E′ force will be larger, and 15 million jobs will not
be sufficient for full employment. The produc-
Pizzas (in hundred thousands) 0 2 4 6 8
tion possibilities curve may shift, but at the
Robots (in thousands) 14 12 9 5 0 future date the economy may fail to produce at
a point on that new curve.
38 Part One • An Introduction to Economics and the Economy

ADVANCES IN TECHNOLOGY
Our second assumption is that we have constant, unchanging technology. In reality,
technology has progressed dramatically over time. An advancing technology brings
both new and better goods and improved ways of producing them. For now, let’s
think of technological advances as being only improvements in capital facilities—
more efficient machinery and equipment. These advances alter our previous dis-
cussion of the economic problem by improving productive efficiency, thereby
allowing society to produce more goods with fixed resources. As with increases in
resource supplies, technological advances make possible the production of more
robots and more pizzas.
Thus, when either supplies of resources increase or an improvement in technol-
ogy occurs, the production possibilities curve in Figure 2-3 shifts outward and to the
right, as illustrated by curve A′, B′, C′, D′, E′ in Figure 2-4. Such an outward shift of
the production possibilities curve represents growth of economic capacity or, sim-
economic ply, economic growth: the ability to produce a larger total output. This growth is the
growth An result of (1) increases in supplies of resources, (2) improvements in resource qual-
outward shift in the ity, and (3) technological advances.
production possibil-
ities curve that The consequence of growth is that our full-employment economy can enjoy a
results from an greater output of both robots and pizzas. While a static, no-growth economy must sac-
increase in resource rifice some of one product in order to get more of another, a dynamic, growing economy can
supplies or quality have larger quantities of both products.
or an improvement Economic growth does not ordinarily mean proportionate increases in a nation’s
in technology.
capacity to produce all its products. Note in Figure 2-4 that, at the maximums, the
economy can produce twice as many pizzas as before but only 40 percent more
robots. To reinforce your understanding of this concept, sketch in two new produc-

FIGURE 2-4 ECONOMIC GROWTH AND THE PRODUCTION

POSSIBILITIES CURVE
The increase in sup- Q
plies of resources, A′
the improvements in 14
resource quality, and 13
the technological B′
advances that occur 12
in a dynamic econ- 11
Robots (thousands)

omy move the pro- 10

duction possibilities C′
curve outward and 9
to the right, allowing 8
the economy to have 7
larger quantities of
both types of goods. 6
D′
5
4
3
2
1
E′
Q
0 1 2 3 4 5 6 7 8
Pizzas (hundred thousands)
 chapter two • the economic problem: scarcity, wants, and choices 39

tion possibilities curves: one showing the situation where a better technique for pro-
ducing robots has been developed while the technology for producing pizzas is
unchanged, and the other illustrating an improved technology for pizzas while the
technology for producing robots remains constant.

PRESENT CHOICES AND FUTURE POSSIBILITIES

An economy’s current position on its production possibilities curve is a basic
determinant of the future location of that curve. Let’s designate the two axes of the
production possibilities curve as goods for the future and goods for the present, as in
Figure 2-5. Goods for the future are such things as capital goods, research and edu-
cation, and preventive medicine. They increase the quantity and quality of property
resources, enlarge the stock of technological information, and improve the quality
of human resources. As we have already seen, goods for the future, like industrial
robots, are the ingredients of economic growth. Goods for the present are pure con-
sumer goods, such as pizza, clothing, and soft drinks.
Now suppose there are two economies, Alta and Zorn, which are initially identi-
cal in every respect except one: Alta’s current choice of positions on its production
possibilities curve strongly favours present goods over future goods. Point A in Fig-
ure 2-5(a) indicates that choice. It is located quite far down the curve to the right,
indicating a high priority for goods for the present, at the expense of fewer goods
for the future. Zorn, in contrast, makes a current choice that stresses larger amounts
of future goods and smaller amounts of present goods, as shown by point Z in Fig-
ure 2-5(b).
Other things equal, we can expect the future production possibilities curve of
Zorn to be farther to the right than Alta’s curve. By currently choosing an output
more favourable to technological advances and to increases in the quantity and
quality of resources, Zorn will achieve greater economic growth than Alta. In terms

FIGURE 2-5 AN ECONOMY’S PRESENT POSITION ON ITS

PRODUCTION POSSIBILITIES CURVE DETERMINES
THE CURVE’S FUTURE LOCATION
A nation’s current
choice favouring
“present goods,” as
made by Alta in (a),
will cause a modest
Goods for the future

Goods for the future

outward shift of the

Future Future
curve in the future. curve curve
A nation’s current Z
choice favouring
“future goods,” as
made by Zorn in (b),
will result in a greater Current Current
outward shift of the curve curve
curve in the future. A

0 Goods for the present 0 Goods for the present

(a) Alta (b) Zorn
40 Part One • An Introduction to Economics and the Economy

of capital goods, Zorn is choosing to make larger current additions to its “national
factory”—to invest more of its current output—than Alta. The payoff from this
choice for Zorn is more rapid growth—greater future production capacity. The
opportunity cost is fewer consumer goods in the present for Zorn to enjoy. (See
Global Perspective 2.1.)
Is Zorn’s choice thus “better” than Alta’s? That, we cannot say. The different out-
comes simply reflect different preferences and priorities in the two countries. (Key
Question 10 and 11)

A Qualification: International Trade

Production possibilities analysis implies that a nation is limited to the combinations
of output indicated by its production possibilities curve. But we must modify this prin-
ciple when international specialization and trade exist.
You will see in later chapters that an economy can avoid, through international
specialization and trade, the output limits imposed by its domestic production pos-
sibilities curve. International specialization means directing domestic resources to out-
put that a nation is highly efficient at producing. International trade involves the
exchange of these goods for goods produced abroad. Specialization and trade
enable a nation to get more of a desired good at less sacrifice of some other good.
Rather than sacrifice three robots to get a third unit of pizza, as in Table 2-1, a nation
might be able to obtain the third unit of pizza by trading only two units of robots
for it. Specialization and trade have the same effect as having more and better
resources or discovering improved production techniques; both increase the quan-
tities of capital and consumer goods available to society.

● Unemployment and the failure to achieve pro-
ductive efficiency cause an economy to operate
at a point inside its production possibilities curve.
● Increases in resource supplies, improvements
in resources quality, and technological advance
cause economic growth, which is depicted as an
outward shift of the production possibilities curve.
● Society’s present choice of capital and con-
sumer goods helps determine the future loca-
tion of its production possibilities curve.
● International specialization and trade enable a
nation to obtain more goods than its production
possibilities curve indicates.

Examples and Applications

There are many possible applications and examples relating to the production pos-
sibilities model. We will discuss just a few of them.

UNEMPLOYMENT AND PRODUCTIVE INEFFICIENCY

Almost all nations have at one point or another experienced widespread unem-
ployment of resources. That is, they have operated inside of their production pos-
sibilities curves. In the depths of the Great Depression of the 1930s, 20 percent of
Canada’s workers were unemployed and one-third of Canadian production capac-
ity was idle. In the last half of the 1990s, several countries (for example, Argentina,
Japan, Mexico, and South Korea) operated inside their production possibilities
curves, at least temporarily, because of substantial declines in economic activity.
 chapter two • the economic problem: scarcity, wants, and choices 41

2.1

national output per person (1970–1990)

4.0
Investment and Japan
economic growth, 3.5 Ireland Portugal

Annual growth rate of real

Norway
selected countries Turkey
Iceland
Finland
3.0 Italy
Austria
Canada Spain
Nations that invest large por- 2.5
Belgium
Greece
Luxembourg
Germany France
tions of their national output U.K. Denmark
2.0
Netherlands
tend to achieve high growth
U.S. Sweden Australia
1.5
rates, measured here by out-
Switzerland
put per person. Additional 1.0 New Zealand

capital goods make workers 0.5

16 18 20 22 24 26 28 30 32
more productive, which means Investment as share of national output
greater output per person. (average, 1970–1990)
Source: International Monetary Fund

Economies that experience substantial discrimination based on race, ethnicity,

and gender do not achieve productive efficiency and thus operate inside their pro-
duction possibilities curves. Because discrimination prevents those discriminated
against from obtaining jobs that best use their skills, society has less output than
otherwise. Eliminating discrimination would move such an economy from a point
inside of its production possibilities curve toward a point on its curve. Similarly,
economies in which labour usage and production methods are based on custom,
heredity, and caste, rather than on efficiency, operate well inside their production
possibilities curves.

TRADEOFFS AND OPPORTUNITY COSTS

Many current controversies illustrate the tradeoffs and opportunity costs indicated
Facing
Tradeoffs in movements along a particular production possibilities curve. (Any two categories
of “output” can be placed on the axes of production possibilities curves.) Should
scenic land be used for logging and mining or preserved as wilderness? If the land
is used for logging and mining, the opportunity cost is the forgone benefits of
wilderness. If the land is used for wilderness, the opportunity cost is the lost value
of the wood and minerals that society forgoes.
Should society devote more resources to the criminal justice system (police,
courts, and prisons) or to education (teachers, books, and schools)? If society
devotes more resources to the criminal justice system, other things equal, the oppor-
tunity cost is forgone improvements in education. If more resources are allocated to
education, the opportunity cost is the forgone benefits from an improved criminal
justice system.

SHIFTS IN PRODUCTION POSSIBILITIES CURVES

Canada has recently experienced a spurt of new technologies relating to computers,
communications, and biotechnology. Technological advances have dropped the
prices of computers and greatly enhanced their speed. Cellular phones and the
Internet have increased communications capacity, enhancing production and
improving the efficiency of markets. Advances in biotechnology, specifically genetic
engineering, have resulted in important agricultural and medical discoveries. Many
42 Part One • An Introduction to Economics and the Economy

economists believe that these new technologies are so significant that they are con-
tributing to faster-than-normal economic growth (faster rightward shifts of the pro-
duction possibilities curve).
In some circumstances a nation’s production possibilities curve can collapse
inward. For example, in the late 1990s Yugoslavia forces began to “ethnically cleanse”
Kosovo by driving out its Muslim residents. A decisive military response by Canada
and its allies eventually pushed Yugoslavia out of Kosovo. The military action also
devastated Yugoslavia’s economy. Allied bombing inflicted great physical damage on
Yugoslavia’s production facilities and its system of roads, bridges, and communica-
tion. Consequently, Yugoslavia’s production possibilities curve shifted inward.

Economic Systems
economic Every society needs to develop an economic system—a particular set of institutional
system A par- arrangements and a coordinating mechanism—to respond to the economic problem.
ticular set of institu- Economic systems differ as to (1) who owns the factors of production and (2) the
tional arrangements
and a coordinating
method used to coordinate and direct economic activity. There are two general types
mechanism for of economic systems: the market system and the command system.
solving the econo-
mizing problem.
The Market System
The private ownership of resources and the use of markets and prices to coordinate
market and direct economic activity characterize the market system, or capitalism. In that
system An system each participant acts in his or her own self-interest; each individual or busi-
economic system ness seeks to maximize its satisfaction or profit through its own decisions regarding
in which property
resources are pri-
consumption or production. The system allows for the private ownership of capi-
vately owned and tal, communicates through prices, and coordinates economic activity through mar-
markets and prices kets—places where buyers and sellers come together. Goods and services are
are used to direct produced and resources are supplied by whoever is willing and able to do so. The
and coordinate eco- result is competition among independently acting buyers and sellers of each prod-
nomic activities.
uct and resource. Thus, economic decision making is widely dispersed.
In pure capitalism—or laissez-faire capitalism—government’s role is limited to
protection private property and establishing an environment appropriate to the
operation of the market system. The term laissez-faire means “let it be,” that is, keep
government from interfering with the economy. The idea is that such interference
will disturb the efficient working of the market system.
But in the capitalism practised in Canada and most other countries, government
plays a substantial role in the economy. It not only provides the rules for economic
activity but also promotes economic stability and growth, provides certain goods
and services that would otherwise be underproduced or not produced at all, and
modifies the distribution of income. The government, however, is not the dominant
player in deciding what to produce, how to produce it, and who will get it. These
command decisions are determined by market forces.
system An
economic system
in which most prop-
The Command System
erty resources are The alternative to the market system is the command system, also known as social-
owned by the gov- ism or communism. In that system, government owns most property resources and
ernment and eco-
nomic decisions are
economic decision making occurs through a central economic plan. A government
made by a central central planning board determines nearly all the major decisions concerning the use
government body. of resources, the composition and distribution of output, and the organization of
 chapter two • the economic problem: scarcity, wants, and choices 43

production. The government owns most of the business firms, which produce
according to government directives. A central planning board determines produc-
tion goals for each enterprise and specifies the amount of resources to be allocated
to each enterprise so that it can reach its production goals. The division of output
among the population is centrally decided, and capital goods are allocated among
industries on the basis of the central planning board’s long-term priorities.
A pure command economy would rely exclusively on a central plan to allocate the
government-owned property resources. But, in reality, even the pre-eminent com-
mand economy—the Soviet Union—tolerated some private ownership and incor-
porated some markets before its demise in 1991. Recent reforms in Russia and most
of the eastern European nations have to one degree or another transformed their
command economies to market-oriented systems. China’s reforms have not gone as
far, but have reduced the reliance on central planning. Although there is still exten-
sive government ownership of resources and capital in China, it has increasingly
relied on free markets to organize and coordinate its economy. North Korea and
Cuba are the last remaining examples of largely centrally planned economies.

The Circular Flow Model

Because nearly all of the major nations now use the market system, we need to gain
a good understanding of how this system operates. Our goal in the remainder of this
chapter is to identify the market economy’s decision makers and major markets. In
Chapter 3 we will explain how prices are established in individual markets. Then
in Chapter 4 we will detail the characteristics of the market system and explain how
it addresses the economic problem.
resource As shown in Figure 2-6 (Key Graph), the market economy has two groups of
market A mar- decision makers: households and businesses. It also has two broad markets: the
ket in which house-
holds sell and firms
resource market and the product market
buy resources or The upper half of the diagram represents the resource market: the place where
the services of resources or the services of resource suppliers are bought and sold. In the sources market,
resources. households sell resources and businesses purchases them. Households (that is, peo-
ple) own all resources either directly as workers or entrepreneurs or indirectly
product through their ownership (through stocks) of business corporations. They sell their
market A mar-
ket in which prod- resources to businesses, which buy them because they are necessary for producing
ucts are sold by goods and services. The money that businesses pay for resources are costs to busi-
firms and bought nesses but are flows of wage, rent, interest, and profit income to the households.
by households. Resources therefore flow from households to businesses, and money flows from
circular businesses to households.
flow model Next consider the lower part of the diagram that represents the product market:
The flow of the place where goods and services produced by businesses are bought and sold. In the prod-
resources from uct market, businesses combine the resources they have obtained to produce and
households to sell goods and services. Households use the income they have received from the sale
firms and of prod-
ucts from firms to
of resources to buy goods and services. The monetary flow of consumer spending
households. These on goods and services yields sales revenues for businesses.
flows are accompa- The circular flow model shows the interrelated web of decision making and eco-
nied by reverse nomic activity involving businesses and households. Businesses and households are
flows of money both buyers and sellers. Businesses buy resources and sell products. Households buy
from firms to
households and
products and sell resources. As shown in Figure 2-6, there is a counterclockwise real
from households flow of resources and finished goods and services, and a clockwise money flow of
to firms. income and consumption expenditures. These flows are simultaneous and repetitive.
44 Part One • An Introduction to Economics and the Economy

Key Graph FIGURE 2-6 THE CIRCULAR FLOW DIAGRAM

Money
inc
Resources flow from RESOURCE om
households to businesses s MARKET i nt e

e
st
Labou r, re

(w
s

Co
through the resource mar- • Households sell l an

ag
d,

t,
ket and products flow from es • Firms buy
c

pr
rc

es,
p r en
businesses to household eu

of i t
ap
u
ri

so

rent s ,
i ta l
through the product mar-

s)
Re

al
ket. Opposite these real

, entre -
ab i l
flows are monetary flows.

ity
Households receive
income from businesses
(their costs) through the
resource market and busi- BUSINESSES HOUSEHOLDS
nesses receive revenue • Buy resources • Sell resources
from households (their • Sell products • Buy products
expenditures) through the
product market.
Good s

ces

tures
rvi
se
an

d PRODUCT

ndi
se d
r vice MARKET s an
s Good

pe
Re

ex
• Firms sell
ve

nu • Households buy on
e
m pti
Consu

Quick Quiz
1. The resource market is where:
a. households sell products and businesses buy products.
b. businesses sell resources and households sell products.
c. households sell resources and businesses buy resources (or the services of
resources).
d. businesses sell resources and households buy resources (or the services of
resources).
2. Which of the following would be determined in the product market?
a. a manager’s salary
b. the price of equipment used in a bottling plant
c. the price of 80 hectares of farmland
d. the price of a new pair of athletic shoes
3. In this circular flow diagram:
a. money flows counterclockwise.
b. resources flow counterclockwise.
c. goods and services flow clockwise.
d. households are on the selling side of the product market.
4. In this circular flow diagram:
a. households spend income in the product market.
b. firms sell resources to households.
c. households receive income through the product market.
d. households produce goods.
Answers:
1. c; 2. d; 3. b; 4. a
 chapter two • the economic problem: scarcity, wants, and choices
One of the more remarkable
trends of the past half-century in
Canada has been the substantial
rise in the number of women
working in the paid workforce.
Today, nearly 70 percent of
women work full-time or part-
time in paid jobs, compared to
only 31 percent in 1965. There are
many reasons for this increase.
Women’s Rising Wage Rates
Over recent years, women have
greatly increased their productiv-
ity in the workplace, mostly by
becoming better educated and
professionally trained. As a re-
sult, they can earn higher wages.
Because those higher wages have
increased the opportunity costs—
the forgone wage earnings—of
staying at home, women have
substituted employment in the
labour market for more “expen-
sive” traditional home activities.
This substitution has been partic-
ularly pronounced among mar-
ried women.
Women’s higher wages and
longer hours away from home
have produced creative realloca-
tions of time and purchasing
patterns. Daycare services have
partly replaced personal child
care. Restaurants, take-home
meals, and pizza delivery often
substitute for traditional home
cooking. Convenience stores
and catalogue and Internet sales
have proliferated, as have lawn-
care and in-home cleaning serv-
ices. Microwave ovens, dish-
washers, automatic washers and
dryers, and other household
WOMEN AND EXPANDED
PRODUCTION POSSIBILITIES
A large increase in the number of employed women has
shifted the U.S. production possibilities curve outward.
“capital goods” enhance domes-
tic productivity.
Expanded Job Access Greater
access to jobs is a second factor
increasing the employment of
women. Service industries—
teaching, nursing, and clerical
work, for instance—that tradi-
tionally have employed mainly
women have expanded in the
past several decades. Also, pop-
ulation in general has shifted
from farms and rural regions to
urban areas, where jobs for
women are more abundant and
more geographically accessible.
The decline in the average
length of the workweek and the
increased availability of part-
time jobs have also made it eas-
ier for women to combine labour
market employment with child-
rearing and household activities.
Changing Preferences and Atti-
tudes Women collectively have
changed their preferences from
household activities to employ-
ment in the labour market. Many
find personal fulfillment in jobs,
careers, and earnings, as evi-
denced by the huge influx of
women into law, medicine, busi-
ness, and other professions.
45
More broadly, most industrial
societies now widely accept and
encourage labour force partici-
pation by women, including
those with very young children.
Today about 60 percent of Cana-
dian mothers with preschool
children participate in the labour
force, compared to only 30 per-
cent in 1970. More than half
return to work before their
youngest child has reached the
age of two.
Declining Birthrates There were
3.8 lifetime births per woman in
1957 at the peak of the baby
boom. Today the number is less
than 2. This marked decline in
the size of the typical family, the
result of changing lifestyles and
the widespread availability of
birth control, has freed up time
for greater labour-force partici-
pation by women. Not only do
women now have fewer chil-
dren; their children are spaced
closer together in age. Thus
women who leave their jobs dur-
ing their children’s early years
can return to the labour force
sooner. Higher wage rates have
also been at work. On average,
women with relatively high
wage earnings have fewer chil-
dren than women with lower
earnings. The opportunity cost
of children—the income sacri-
ficed by not being employed—
rises as wage earnings rise. In
the language of economics, the
higher “price” associated with
children has reduced the “quan-
tity” of children demanded.
46 Part One • An Introduction to Economics and the Economy

Rising Divorce Rates Marital in-
stability, as evidenced by high
divorce rates, may have moti-
vated many women to enter and
remain in the labour market. Be-
cause alimony and child support
payments are often erratic or
non-existent, the economic im-
pact of divorce on non-working
women may be disastrous. Most
non-working women enter the
labour force for the first time
following divorce. And many
married women—perhaps even
women contemplating marriage
—may have joined the labour
force to protect themselves
against the financial difficulties
of potential divorce.
Slower growth of male wages
The earnings of many low-wage
and middle-wage male workers
grew slowly or even fell in
Canada over the past three
decades. Many wives may have
entered the labour force to en-
sure the rise of household living
standards. The median income
of couples with children grew 25
percent between 1969 and 1996.
Without the mothers’ income,
that growth would have been
only 2 percent. Couples of all in-
come levels may be concerned
about their family income com-
pared to other families. So, the
entry of some women into the
labour force may have encour-
aged still other women to enter
in order to maintain their fami-
lies’ relative standard of living.
Taken together, these factors
have produced a rapid rise in the
presence of women workers in
Canada. This increase in the quan-
tity of resources has helped push
the Canadian production possibil-
ities curve outward. In other
words, it has contributed greatly
to Canada’s economic growth.

chapter summary
1. Economics is grounded on two basic facts:
(a) wants are virtually unlimited; (b) resources
are scarce.
2. Resources may be classified as property re-
sources—raw materials and capital—or as
human resources—labour and entrepreneur-
ial ability. These resources constitute the fac-
tors of production.
3. Economics is concerned with the problem of
using scarce resources to produce the goods
and services that satisfy the material wants of
society. Both full employment and the effi-
cient use of available resources are essential
to maximize want satisfaction.
4. Efficient use of resources consists of produc-
tive efficiency (producing all output combina-
tions in the least costly way) and allocative
efficiency (producing the specific output mix
most desired by society).
5. An economy that is achieving full employ-
ment and productive efficiency—that is oper-
ating on its production possibilities curve—
must sacrifice the output of some types of
goods and services in order to increase the
production of others. Because resources are
not equally productive in all possible uses,
shifting resources from one use to another
brings the law of increasing opportunity costs
into play. The production of additional units of
one product requires the sacrifice of increas-
ing amounts of the other product.
6. Allocative efficiency means operating at the
optimal point on the production possibilities
curve. That point represents the highest-
valued mix of goods and is determined by
expanding the production of each good until
its marginal benefit (MB) equals its marginal
cost (MC).
7. Over time, technological advances and
increases in the quantity and quality of
resources enable the economy to produce
more of all goods and services—that is, to
experience economic growth. Society’s
choice as to the mix of consumer goods and
capital goods in current output is a major
determinant of the future location of the pro-
duction possibilities curve and thus of eco-
nomic growth.
8. The market system and the command system
are the two broad types of economic systems
 chapter two • the economic problem: scarcity, wants, and choices 47

used to address the economic problem. In
the market system (or capitalism) private indi-
viduals own most resources and markets
coordinate most economic activity. In the
command system (or socialism or commu-
nism), government owns most resources and
central planners coordinate most economic
activity.
9. The circular flow model locates the product
and resource markets and shows the major
real and money flows between businesses
and households. Businesses are on the buy-
ing side of the resource market and the selling
side of the product market. Households are on
the selling side of the resource market and the
buying side of the product market.

terms and concepts

allocative efficiency, p. 30
capital, p. 28
capital goods, p. 31
circular flow model, p. 43
command system, p. 42
consumer goods, p. 31
economic growth, p. 38
economic problem, p. 27
economic resources, p. 28
economic system, p. 42
entrepreneurial ability, p. 28
factors of production, p. 29
full employment, p. 29
full production, p. 30
investment, p. 28
labour, p. 28
land, p. 28
law of increasing opportunity
costs, p. 34
market system, p. 42
opportunity cost, p. 32
product market, p. 43
production possibilities curve,
p. 32
production possibilities table,
p. 31
productive efficiency, p. 30
resource market, p. 43
utility, p. 27

study questions
1. Explain this statement: “If resources were PRODUCTION
unlimited and were freely available, there ALTERNATIVES
would be no subject called economics.” Type of production A B C D E
2. Comment on the following statement from a Automobiles 0 2 4 6 8
newspaper article: “Our junior high school
Rockets 30 27 21 12 0
serves a splendid hot meal for $1 without
costing the taxpayers anything, thanks in
part to a government subsidy.” a. Show these data graphically. Upon what
specific assumptions is this production
3. Critically analyze: “Wants aren’t insatiable. I possibilities curve based?
can prove it. I get all the coffee I want to
b. If the economy is at point C, what is the
drink every morning at breakfast.” Explain:
cost of one more automobile? One more
“Goods and services are scarce because
rocket? Explain how the production pos-
resources are scarce.” Analyze: “It is the
sibilities curve reflects the law of increas-
nature of all economic problems that
ing opportunity costs.
absolute solutions are denied to us.”
c. What must the economy do to operate at
4. What are economic resources? What are the some point on the production possibili-
major functions of the entrepreneur? ties curve?
7. What is the opportunity cost of attending
5. KEY QUESTION Why is the problem
college or university? In 1999 nearly 80 per-
of unemployment part of the subject matter
cent of Canadians with post-secondary edu-
of economics? Distinguish between produc-
cation held jobs, whereas only about 40
tive efficiency and allocative efficiency. Give
percent of those who did not finish high
an illustration of achieving productive, but
school held jobs. How might this difference
not allocative, efficiency.
relate to opportunity costs?
6. KEY QUESTION Here is a production 8. Suppose you arrive at a store expecting to
possibilities table for war goods and civilian pay $100 for an item but learn that a store
goods: two kilometres away is charging $50 for it.
48 Part One • An Introduction to Economics and the Economy
Would you drive there and buy it? How
does your decision benefit you? What is the
opportunity cost of your decision? Now sup-
pose you arrive at a store expecting to pay
$6000 for an item but discover that it costs
$5950 at the other store. Do you make the
same decision as before? Perhaps surpris-
ingly, you should! Explain why.
9. KEY QUESTION Specify and explain
the shapes of the marginal-benefit and mar-
ginal-cost curves. How are these curves used
to determine the optimal allocation of re-
sources to a particular product? If current
output is such that marginal cost exceeds
marginal benefit, should more or fewer re-
sources be allocated to this product? Explain.
10. KEY QUESTION Label point G inside
the production possibilities curve you drew
in question 6. What does it indicate? Label
point H outside the curve. What does that
point indicate? What must occur before the
economy can attain the level of production
shown by point H?
11. KEY QUESTION Referring again to
question 6, suppose improvement occurs in the
technology of producing rockets but not in the
technology of producing automobiles. Draw
the new production possibilities curve. Now
assume that a technological advance occurs in
producing automobiles but not in producing
rockets. Draw the new production possibilities
curve. Now draw a production possibilities
curve that reflects technological improvement
in the production of both products.
12. Explain how, if at all, each of the following
events affects the location of the production
possibilities curve:
internet application questions
1. More Labour Resources—What is the Evi-
dence for Canada and France? Go to the
U.S. Bureau of Labor Statistic’s Web site
www.bls.gov/ and click Data and then Most
Requested Series. Click International Labor
Statistics and retrieve Canadian employment
data for the period of the last 10 years. How
many more workers were there at the end of
the 10-year period than at the beginning?
Next find the total employment growth of
Italy over the last 10 years. In which of the
two countries did “more labour resources”
have the greatest impact on the nation’s pro-
duction possibilities curve over the 10 years?
a. Standardized examination scores of high
school, university, and college students
decline.
b. The unemployment rate falls from 9 to 6
percent of the labour force.
c. Defence spending is reduced to allow gov-
ernment to spend more on health care.
d. A new technique improves the efficiency
of extracting copper from ore.
13. Explain: “Affluence tomorrow requires sacri-
fice today.”
14. Suppose that, based on a nation’s produc-
tion possibilities curve, an economy must
sacrifice 10,000 pizzas domestically to get
the one additional industrial robot it desires,
but that it can get the robot from another
country in exchange for 9000 pizzas. Relate
this information to the following statement:
“Through international specialization and
trade, a nation can reduce its opportunity
cost of obtaining goods and thus ‘move out-
side its production possibilities curve.’ ”
15. Contrast how a market system and a command
economy respond to the economic problem.
16. Distinguish between the resource market
and product market in the circular flow
model. In what way are businesses and
households both sellers and buyers in this
model? What are the flows in the circular
flow model?
17. (Last Word) Which two of the six reasons
listed in the Last Word do you think are
the most important in explaining the rise in
participation of women in the workplace?
Explain your reasoning.
2. Relative Size of the Military—Who’s Incur-
ring the Largest Opportunity Cost? To obtain
military goods, a nation must sacrifice civil-
ian goods. Of course, that sacrifice may be
worthwhile in terms of national defence and
protection of national interests. Go to the
U.S. Central Intelligence Agencies Web
site www.odci.gov/cia/publications/factbook/
country.html to determine the amount of
military expenditures and military expendi-
tures as a percentage of GDP, for each of the
following five nations: Canada, Japan, North
Korea, Russia, and the United States. Who is
bearing the greatest opportunity costs?
 THREE

Individual
Markets
Demand and Supply

A
ccording to an old joke, if you teach a

parrot to say “Demand and supply,”

you have an economist. There is much

truth in this quip. The tools of demand and

IN THIS CHAPTER
Y OU WILL LEARN: supply can take us far in understanding both

What markets are. specific economic issues and how the entire
•
What demand is and economy works.
what factors affect it.
• With our circular flow model in Chapter 2,
What supply is and
we identified the participants in the product
what factors affect it.
• market and resource market. We asserted
How demand and
supply together determine that prices were determined by the “interac-
market equilibrium.
tion” between buyers and sellers in those

markets. In this chapter we examine that

interaction in detail and explain how prices

and output quantities are determined.

50 Part One • An Introduction to Economics and the Economy

Markets
market Any Recall from Chapter 2 that a market is an institution or mechanism that brings together
institution or mech- buyers (“demanders”) and sellers (“suppliers”) of particular goods, services, or resources for
anism that brings the purpose of exchange. Markets exist in many forms. The corner gas station, e-com-
together buyers and
sellers of particular merce sites, the local music store, a farmer’s roadside stand—all are familiar mar-
goods, services, kets. The Toronto Stock Exchange and the Chicago Board of Trade are markets
or resources for where buyers and sellers of stocks and bonds and farm commodities from all over
the purpose of the world communicate with one another to buy and sell. Auctioneers bring
exchange. together potential buyers and sellers of art, livestock, used farm equipment, and,
sometimes, real estate. In labour markets, the professional hockey player and his
agent bargain with the owner of an NHL team. A graduating finance major inter-
views with the Canadian Imperial Bank of Commerce or Scotiabank at the univer-
sity placement office.
www.tse.com All situations that link potential buyers with potential sellers are markets. Some
Toronto Stock markets are local, while others are national or international. Some are highly per-
Exchange sonal, involving face-to-face contact between demander and supplier; others are
impersonal, with buyer and seller never seeing or knowing each other.
To keep things simple, we will focus in this chapter on markets consisting of large
numbers of buyers and sellers of standardized products. These are the highly com-
petitive markets such as a central grain exchange, a stock market, or a market for
foreign currencies in which the price is “discovered” through the interacting deci-
sions of buyers and sellers. They are not the markets in which one or a handful of
producers “set” prices, such as the markets for commercial airplanes or operating
software for personal computers.

Demand
Recall from Chapter 2 that the economic problem consists of unlimited wants and
limited resources to produce the goods and services to satisfy those wants. We begin
now to take a closer look at the nature of wants, or demand. Later in the chapter we
will investigate the nature of supply.
Demand A Demand is a schedule or a curve that shows the various amounts of a product that con-
schedule or curve sumers are willing and able to purchase at each of a series of possible prices during a speci-
that shows the fied period of time.1 Demand shows the quantities of a product that will be purchased
various amounts
of a product that at various possible prices, other things equal. Demand can easily be shown in table
consumers are form. Table 3-1 is a hypothetical demand schedule for a single consumer purchasing
willing and able to bushels of corn.
purchase at each of Table 3-1 reveals the relationship between the various prices of corn and the
a series of possible quantity of corn a particular consumer would be willing and able to purchase at
prices during a
specified period each of these prices. We say willing and able because willingness alone is not effec-
of time. tive in the market. You may be willing to buy a Porsche, but if that willingness is not
backed by the necessary dollars, it will not be effective and, therefore, will not be
reflected in the market. In Table 3-1, if the price of corn was $5 per bushel, our con-
sumer would be willing and able to buy 10 bushels per week; if it was $4, the con-
sumer would be willing and able to buy 20 bushels per week; and so forth.

1
This definition obviously is worded to apply to product markets. To adjust it to apply to resource
markets, substitute the word “resource” for “product” and the word “businesses” for “consumers.”
 chapter three • individual markets: demand and supply 51

Table 3-1 does not tell us which of the five pos-

TABLE 3-1 AN INDIVIDUAL sible prices will actually exist in the corn market.
BUYER’S DEMAND That depends on demand and supply. Demand
FOR CORN is simply a statement of a buyer’s plans, or inten-
tions, with respect to the purchase of a product.
Price per bushel Quantity demanded per week
To be meaningful, the quantities demanded
$5 10 at each price must relate to a specific period—a
4 20 day, a week, a month. Saying “A consumer will
buy 10 bushels of corn at $5 per bushel” is
3 35
meaningless. Saying “A consumer will buy 10
2 55 bushels of corn per week at $5 per bushel” is
1 80 meaningful. Unless a specific time period is
stated, we do not know whether the demand
for a product is large or small.

Law of Demand
A fundamental characteristic of demand is this: All else equal, as price falls, the quan-
law of tity demanded rises, and as price rises, the quantity demanded falls. In short, there is a
demand The negative or inverse relationship between price and quantity demanded. This inverse
principle that, other relationship is called the law of demand.
things equal, an
increase in a prod-
The “other things equal” assumption is critical here. Many factors other than the
uct’s price will price of the product being considered affect the amount purchased. The quantity of
reduce the quantity Nikes purchased will depend not only on the price of Nikes but also on the prices
of it demanded; of such substitutes as Reeboks, Adidas, and Filas. The law of demand in this case
and conversely for says that fewer Nikes will be purchased if the price of Nikes rises and if the prices of
a decrease in price.
Reeboks, Adidas, and Filas all remain constant. In short, if the relative price of Nikes rises,
marginal fewer Nikes will be bought. However, if the price of Nikes and all other competing
utility The shoes increase by some amount—say, $5—consumers might buy more, fewer, or the
extra utility a con- same amount of Nikes.
sumer obtains from Why the inverse relationship between price and quantity demanded? Let’s look
the consumption
of one additional
at two explanations:
unit of a good or ● In any specific time period, each buyer of a product will derive less satisfac-
service.
tion (or benefit, or utility) from each successive unit of the product consumed.
income The second Big Mac will yield less satisfaction to the consumer than the first,
effect A and the third still less than the second. That is, consumption is subject to
change in the price diminishing marginal utility. And because successive units of a particular
of a product changes product yield less and less marginal utility, consumers will buy additional
a consumer’s real
income (purchasing
units only if the price of those units is progressively reduced.
power) and thus the ● We can also explain the law of demand in terms of income and substitution
quantity of the prod-
uct purchased.
effects. The income effect indicates that a lower price increases the purchas-
ing power of a buyer’s money income, enabling the buyer to purchase more of
substitu- the product than she or he could buy before. A higher price has the opposite
tion effect effect. The substitution effect suggests that at a lower price, buyers have the
A change in the price incentive to substitute what is now a less expensive product for similar prod-
of a consumer good
changes the relative
ucts that are now relatively more expensive. The product whose price has fallen
expensiveness of is now “a better deal” relative to the other products.
that good and hence
changes the willing-
For example, a decline in the price of chicken will increase the purchasing power
ness to buy it rather of consumer incomes, enabling them to buy more chicken (the income effect). At a
than other goods. lower price, chicken is relatively more attractive and consumers tend to substitute
52 Part One • An Introduction to Economics and the Economy

it for pork, mutton, beef, and fish (the substitution effect). The income and substi-
tution effects combine to make consumers able and willing to buy more of a prod-
uct at a low price than at a high price.

The Demand Curve

The inverse relationship between price and quantity demanded for any product can
be represented on a simple graph, in which, by convention, we measure quantity
demanded on the horizontal axis and price on the vertical axis. In Figure 3-1 we have
plotted the five price-quantity data points listed in Table 3-1 and connected the
demand points with a smooth curve, labelled D. Such a curve is called a demand curve. Its
curve A curve downward slope reflects the law of demand—more people buy more of a product,
illustrating the service, or resource, as its price falls. The relationship between price and quantity
inverse (negative)
relationship
demanded is inverse.
between the Table 3-1 and Figure 3-1 contain exactly the same data and reflect the same rela-
quantity demanded tionship between price and quantity demanded. But the graph shows that relation-
of a good or service ship more simply and clearly than a table or a description in words.
and its price, other
things equal.
Market Demand
So far, we have concentrated on just one consumer. By adding the quantities
demanded by all consumers at each of the various possible prices, we can get from
individual demand to market demand. If there are just three buyers in the market, as
represented in Table 3-2, it is relatively easy to determine the total quantity
demanded at each price. Figure 3-2 shows the graphical summing procedure: At
each price we add the individual quantities demanded to obtain the total quantity
demanded at that price; we then plot the price and the total quantity demanded as
one point of the market demand curve.

FIGURE 3-1 An individual buyer’s demand for corn

Because price and P
quantity demanded
are inversely related,
an individual’s
demand schedule $5
graphs as a down-
Price (per bushel)

sloping curve such as

D. Specifically, the 4
law of demand says
that, other things
3
equal, consumers will
buy more of a product
as its price declines.
2
Here and in later
figures, P stands
for price, and Q 1
stands for quantity D
(either demanded
or supplied.)
0 10 20 30 40 50 60 70 80 Q
Quantity demanded (bushels per week)
 chapter three • individual markets: demand and supply 53

Of course, there are usually many more than

TABLE 3-2 MARKET DEMAND three buyers of a product. To avoid hundreds or
FOR CORN, THREE thousands or millions of additions, we suppose
BUYERS that all the buyers in a market are willing and
able to buy the same amounts at each of the
Quantity demanded Total
Price quantity possible prices. Then we just multiply those
per First Second Third demanded amounts by the number of buyers to obtain the
bushel buyer buyer buyer per week market demand. This is the way we arrived at
curve D1, in Figure 3-3, for a market with 200
$5 10 + 12 + 8 = 30 corn buyers whose demand is that shown in
4 20 + 23 + 17 = 60 Table 3-1. Table 3-3 shows the calculations.
3 35 + 39 + 26 = 100 In constructing a demand curve such as D1 in
2 55 + 60 + 39 = 154 Figure 3-3, we assume that price is the most
1 80 + 87 + 54 = 221 important influence on the amount of any prod-
uct purchased, even though other factors can
and do affect purchases. These factors, called
determinants of demand, are assumed to be con-
determi- stant when a demand curve like D1 is drawn. They are the “other things equal” in
nants of the relationship between price and quantity demanded. When any of these deter-
demand Fac- minants changes, the demand curve will shift to the right or left. For this reason,
tors other than its
price that determine
determinants of demand are sometimes referred to as demand shifters.
the quantities The basic determinants of demand are (1) consumers’ tastes (preferences), (2) the
demanded of a number of consumers in the market, (3) consumers’ incomes, (4) the prices of
good or service. related goods, and (5) consumer expectations about future prices and incomes.

Change in Demand
A change in one or more of the determinants of demand will change the demand
data (the demand schedule) in Table 3-3 and therefore the location of the demand
curve in Figure 3-3. A change in the demand schedule, or graphically, a shift in the
demand curve, is called a change in demand.
If consumers desire to buy more corn at each possible price than is reflected in col-
umn 4 in Table 3-3, that increase in demand is shown as a shift of the demand curve to
the right, say, from D1 to D2. Conversely, a decrease in demand occurs when consumers

FIGURE 3-2 MARKET DEMAND FOR CORN, THREE BUYERS

P P P P

+ + = (Market)
$3 $3 $3 $3 D
D1 D2 D3
Q Q Q Q
0 35 0 39 0 26 0 100
(= 35 + 39 +26)
We establish the market demand curve D by adding horizontally the individual demand curves (D1, D2, and D3) of all the con-
sumers in the market. At the price of $3, for example, the three individual curves yield a total quantity demanded of 100 bushels.
54 Part One • An Introduction to Economics and the Economy

FIGURE 3-3 CHANGES IN THE DEMAND FOR CORN

A change in one or more P
of the determinants of
demand causes a change
in demand. An increase in $5
demand is shown as a shift
of the demand curve to

Price (per bushel)

the right, as from D1 to D2. 4
Increase in demand
A decrease in demand is
shown as a shift of the a
3
demand curve to the left,
as from D1 to D3. These b
changes in demand are 2
to be distinguished from D2
a change in quantity
demanded, which is 1
Decrease D1
caused by a change in the in demand D3
price of the product, as Q
shown by a movement 0 2 4 6 8 10 12 14 16 18 20 22
from, say, point a to point b Quantity demanded (thousands of bushels per week)
on fixed demand curve D1.

buy less corn at each possible price than is indicated in column 4, Table 3-3. The left-
ward shift of the demand curve from D1 to D3 in Figure 3-3 shows that situation.
Now let’s see how changes in each determinant affect demand.

TASTES
A favourable change in consumer tastes (preferences) for a product—a change that
makes the product more desirable—means that more of it will be demanded at
each price. Demand will increase; the demand curve will shift rightward. An
unfavourable change in consumer preferences will decrease demand, shifting the
demand curve to the left.
New products may affect consumer tastes; for example, the introduction of com-
pact discs greatly decreased the demand for cassette tapes. Consumers’ concern
over the health hazards of cholesterol and obe-
sity have increased the demand for broccoli,
TABLE 3-3 MARKET DEMAND low-calorie sweeteners, and fresh fruit, while
FOR CORN, 200 decreasing the demand for beef, veal, eggs, and
BUYERS whole milk. Over the past several years, the
(1) (2) (3) (4) demand for coffee drinks, bottled water, and
Price Quantity Number Total sports utility vehicles has greatly increased,
per demanded of buyers quantity driven by a change in tastes. So, too, has the
bushel per week, in the demanded demand for cargo pants and fleece outerwear.
single buyer market per week

$5 10 × 200 = 2,000 NUMBER OF BUYERS

4 20 × 200 = 4,000 An increase in the number of buyers in a market
3 35 × 200 = 7,000 increases demand. A decrease in the number
of buyers in a market decreases demand. For
2 55 × 200 = 11,000
example, the baby boom after World War II
1 80 × 200 = 16,000
increased demand for diapers, baby lotion, and
the services of obstetricians. When the baby
 chapter three • individual markets: demand and supply 55

boomers reached their 20s in the 1970s, the demand for housing increased. Con-
versely, the aging of the baby boomers in the 1980s and 1990s was a factor in the rel-
ative slump in the demand for housing in those decades. Also, an increase in life
expectancy has increased the demand for medical care, retirement communities, and
nursing homes. And international trade agreements have reduced foreign trade bar-
riers to Canadian farm commodities, thus increasing the demand for those products.

INCOME
How changes in income affect demand is more complex. For most products, a rise
in income causes an increase in demand. Consumers typically buy more steaks, fur-
niture, and computers as their incomes increase. Conversely, the demand for such
products declines as income falls. Products for which demand varies directly with
normal money income are called normal goods.
good A good Although most products are normal goods, there are some exceptions. As incomes
or service whose increase beyond some point, the demand for used clothing, retread tires, and third-
consumption rises
when income
hand automobiles may decrease, because the higher incomes enable consumers to
increases and buy new versions of those products. Rising incomes may also decrease the demand
falls when income for soy-enhanced hamburgers. Similarly, rising incomes may cause the demand for
decreases, price charcoal grills to decline as wealthier consumers switch to gas grills. Goods for which
remaining constant. demand varies inversely with money income are called inferior goods.
inferior
good A good or PRICES OF RELATED GOODS
service whose con- A change in the price of a related good may either increase or decrease the demand
sumption declines for a product, depending on whether the related good is a substitute or a complement.
as income rises
(and conversely), ● A substitute good is one that can be used in place of another good.
price remaining
constant. ● A complementary good is one that is used together with another good.

substitute Substitutes Beef and chicken are examples of substitute goods, or simply substi-
goods Products tutes. When the price of beef rises, consumers buy less beef, increasing the demand
or services that can for chicken. Conversely, as the price of beef falls, consumers buy more beef, decreas-
be used in place of ing the demand for chicken. When two products are substitutes, the price of one and the
each other.
demand for the other move in the same direction. So it is with pairs such as Nikes and
complemen- Reeboks, Colgate and Crest, Toyotas and Hondas, and Coke and Pepsi. So-called
tary goods substitution in consumption occurs when the price of one good rises relative to the
Products and serv- price of a similar good.
ices that are used
together. Complements Complementary goods (or simply complements) are goods that are
used together and are usually demanded together. If the price of gasoline falls and,
as a result, you drive your car more often, the extra driving increases your demand
for motor oil. Thus, gas and motor oil are jointly demanded; they are complements.
So it is with ham and eggs, tuition and textbooks, movies and popcorn, cameras and
film. When two products are complements, the price of one good and the demand for the
other good move in opposite directions.
Unrelated Goods The vast majority of goods that are not related to one another are
called independent goods. Examples are butter and golf balls, potatoes and automo-
biles, and bananas and wristwatches. A change in the price of one does not affect the
demand for the other.
Expectations Changes in consumer expectations may shift demand. A newly
formed expectation of higher future prices may cause consumers to buy now in
order to “beat” the anticipated price rises, thus increasing current demand. For
56 Part One • An Introduction to Economics and the Economy

example, when freezing weather destroys much of Florida’s citrus crop, consumers
may reason that the price of orange juice will rise. They may stock up on orange
juice by purchasing large quantities now. In contrast, a newly formed expectation
of falling prices or falling income may decrease current demand for products.
Similarly, a change in expectations relating to future product availability may
affect current demand. In late December 1999 there was a substantial increase in the
demand for gasoline. Reason? Motorists became concerned that the Y2K computer
problem might disrupt fuel pumps or credit card systems.
Finally, a change in expectations concerning future income may prompt con-
sumers to change their current spending. For example, first-round NHL draft
choices may splurge on new luxury cars in anticipation of a lucrative professional
hockey contract. Or workers who become fearful of losing their jobs may reduce
their demand for, say, vacation travel.
In summary, an increase in demand—the decision by consumers to buy larger
quantities of a product at each possible price—may be caused by:
● A favourable change in consumer tastes
● An increase in the number of buyers
● Rising incomes if the product is a normal good
● Falling incomes if the product is an inferior good
● An increase in the price of a substitute good
● A decrease in the price of a complementary good
● A new consumer expectation that prices and income will be higher in the
future
You should “reverse” these generalizations to explain a decrease in demand. Table 3-4
provides additional illustrations of the determinants of demand. (Key Question 2)

TABLE 3-4 DETERMINANTS OF DEMAND: FACTORS THAT SHIFT

THE DEMAND CURVE
Determinant Examples

Change in buyer tastes
Change in number of buyers
Change in income
Change in the prices of
related goods
Change in expectations
Physical fitness rises in popularity, increasing the demand for jogging
shoes and bicycles; Latin American music becomes more popular,
increasing the demand for Latin CDs.
A decline in the birthrate reduces the demand for children’s toys.
A rise in incomes increases the demand for such normal goods as
butter, lobster, and filet mignon while reducing the demand for such
inferior goods as cabbage, turnips, and inexpensive wine.
A reduction in airfares reduces the demand for bus transportation
(substitute goods); a decline in the price of compact disc players
increases the demand for compact discs (complementary goods).
Inclement weather in South America creates an expectation of higher
future prices of coffee beans, thereby increasing today’s demand for
coffee beans.
 chapter three • individual markets: demand and supply 57

Changes in Quantity Demanded

A change in demand must not be confused with a change in quantity demanded. A
change in change in demand is a shift of the entire demand curve to the right (an increase in
demand A demand) or to the left (a decrease in demand). It occurs because the consumer’s
change in the state of mind about purchasing the product has been altered in response to a change
quantity demanded
of a good or service in one or more of the determinants of demand. Recall that demand is a schedule or
at every price; a a curve; therefore, a change in demand means a change in the entire schedule and a
shift of the demand shift of the entire curve.
curve to the left or In contrast, a change in quantity demanded is a movement from one point to
right. another point—from one price-quantity combination to another—on a fixed
change in demand schedule or demand curve. The cause of such a change is an increase or
quantity decrease in the price of the product under consideration. In Table 3-3, for example,
demanded a decline in the price of corn from $5 to $4 will increase the quantity of corn
A movement demanded from 2000 to 4000 bushels.
from one point In Figure 3-3 the shift of the demand curve D1 to either D2 or D3 is a change in
to another on a
demand curve. demand. But the movement from point a to point b on curve D1 represents a change
in quantity demanded: demand has not changed; it is the entire curve, and it remains fixed
in place.

● A market is any arrangement that facilitates
the purchase and sale of goods, services, or
resources.
● Demand is a schedule or a curve showing the
amount of a product that buyers are willing
and able to purchase at each possible price in
a series of prices, in a particular time period.
● The law of demand states that, other things
equal, the quantity of a good purchased varies
inversely with its price.
● The demand curve shifts because of changes in
(a) consumer tastes, (b) the number of buyers in
the market, (c) consumer income, (d) the prices
of substitute or complementary goods, and
(e) consumer expectations.
● A change in demand is a shift of the entire
demand curve; a change in quantity demanded
is a movement from one point to another on a
demand curve.

Supply
supply A Up to this point we have concentrated our attention on the nature of wants. In order
schedule or curve for wants to be satisfied someone must produce the goods and services desired. We
that shows the now turn to investigate the nature of supply.
amounts of a prod-
uct that producers Supply is a schedule or curve that shows the amounts of a product that producers
are willing and able are willing and able to make available for sale at each of a series of possible prices during a
to make available specific period.2 Table 3-5 is a hypothetical supply schedule for a single producer of
for sale at each of corn. It shows the quantities of corn that will be supplied at various prices, other
a series of possible things equal.
prices during a
specific period.

2
This definition is worded to apply to product markets. To adjust it to apply to resource markets,
substitute resource for product and owner for the word producer.
58 Part One • An Introduction to Economics and the Economy

Law of Supply
TABLE 3-5 AN INDIVIDUAL Table 3-5 shows a direct relationship between
PRODUCER’S price and quantity supplied. As price rises, the
SUPPLY OF CORN quantity supplied rises; as price falls, the quantity
Price per bushel Quantity supplied per week supplied falls. This relationship is called the law
of supply. A supply schedule tells us that firms
$5 60 will produce and offer for sale more of their
4 50 product at a high price than at a low price.
3 35 Price is an obstacle from the standpoint of
2 20 the consumer, who is on the paying end. The
1 5
higher the price, the less the consumer will buy.
But the supplier is on the receiving end of the
product’s price. To a supplier, price represents
revenue, which serves as an incentive to produce
law of and sell a product. The higher the price, the greater the incentive and the greater the
supply The quantity supplied.
principle that, other Consider a farmer who can shift resources among alternative farm products. As
things equal, an
increase in the price price moves up, as shown in Table 3-5, the farmer finds it profitable to take land out
of a product will of wheat, oats, and soybean production and put it into corn. And the higher corn
increase the quan- prices enable the farmer to cover the increased costs associated with more intensive
tity of it supplied; cultivation and the use of more seed, fertilizer, and pesticides. The overall result is
and conversely for more corn.
a price decrease.
Now consider a manufacturer. Beyond some quantity of production, manufac-
turers usually encounter increasing costs per added unit of output. Certain pro-
ductive resources—in particular, the firm’s plant and machinery—cannot be
expanded quickly. So the firm uses more of the other resources, such as labour, to
produce more output. But as time passes, the existing plant becomes increasingly
crowded and congested. As a result, each added worker produces less added out-
put, and the cost of successive units of output rises accordingly. The firm will not
produce those more costly units unless it receives a higher price for them. Again,
price and quantity supplied are directly related.

The Supply Curve

As with demand, it is convenient to represent supply graphically. In Figure 3-4,
curve S1 is a graph of the market supply data given in Table 3-6. Those data assume
there are 200 suppliers in the market, each willing and able to supply corn accord-
supply ing to Table 3-5. We obtain the market supply curve by horizontally adding the sup-
curve A curve
illustrating the posi- ply curves of the individual producers. Note that the axes in Figure 3-4 are the same
tive (direct) relation- as those used in our graph of market demand (Figure 3-3), except for the change
ship between the from “quantity demanded” to “quantity supplied” on the horizontal axis.
quantity supplied of
a good or service
and its price, other Determinants of Supply
things equal.
In constructing a supply curve, we assume that price is the most significant influ-
determi- ence on the quantity supplied of any product. But other factors (the “other things
nants of equal”) can and do affect supply. The supply curve is drawn on the assumption that
supply Factors these other things are fixed and do not change. If one of them does change, a change
other than its price
that determine the in supply will occur, meaning that the entire supply curve will shift.
quantities supplied The basic determinants of supply are (1) resource prices, (2) technology, (3) taxes
of a good or service. and subsidies, (4) prices of other goods, (5) price expectations, and (6) the number
 chapter three • individual markets: demand and supply 59

FIGURE 3-4 CHANGES IN THE SUPPLY OF CORN

A change in one or more P
of the determinants of $6
supply causes a shift S3 S1
in supply. An increase in
supply is shown as a 5
S2
rightward shift of the Decrease

Price (per bushel)

supply curve, as from in supply b
S1 to S2. A decrease in 4
supply is depicted as a
leftward shift of the a
3
curve, as from S1 to S3.
In contrast, a change in Increase
the quantity supplied is in supply
2
caused by a change in
the product’s price
and is shown by a move- 1
ment from one point to
another, as from a to b,
on a fixed supply curve. Q
0 2 4 6 8 10 12 14 16
Quantity supplied (thousands of bushels per week)

of sellers in the market. A change in any one or more of these determinants of sup-
ply, or supply shifters, will move the supply curve for a product either to the right or
to the left. A shift to the right, as from S1 to S2 in Figure 3-4, signifies an increase in
supply: Producers supply larger quantities of the product at each possible price. A
shift to the left, as from S1 to S3, indicates a decrease in supply. Producers offer less
output at each price.

Changes in Supply
Let’s consider how changes in each of the determinants affect supply. The key idea
is that costs are a major factor underlying supply curves; anything that affects costs
(other than changes in output itself) usually
shifts the supply curve.
TABLE 3-6 MARKET SUPPLY
OF CORN, 200 RESOURCE PRICES
PRODUCERS
The prices of the resources used as inputs in the
(1) (2) (3) (4) production process help determine the costs of
Price Quantity Number Total production incurred by firms. Higher resource
per supplied of sellers quantity
prices raise production costs and, assuming a
bushel per week, in the supplied
single producer market per week particular product price, squeeze profits. That
reduction in profits reduces the incentive for
$5 60 × 200 = 12,000 firms to supply output at each product price.
4 50 × 200 = 10,000 For example, an increase in the prices of iron
3 35 × 200 = 7,000 ore and coke will increase the cost of producing
steel and reduce its supply.
2 20 × 200 = 4,000
In contrast, lower resource prices reduce pro-
1 5 × 200 = 1,000
duction costs and increase profits. So, when
resource prices fall, firms supply greater output
60 Part One • An Introduction to Economics and the Economy

at each product price. For example, a decrease in the prices of seed and fertilizer will
increase the supply of corn.

TECHNOLOGY
Improvements in technology (techniques of production) enable firms to produce
units of output with fewer resources. Because resources are costly, using fewer of
them lowers production costs and increases supply. Example: Recent improve-
ments in the fuel efficiency of aircraft engines have reduced the cost of providing
passenger air service. Thus, airlines now offer more flights than previously at each
ticket price; the supply of air service has increased.

TAXES AND SUBSIDIES

Business treat most taxes as costs. An increase in sales or property taxes will increase
production costs and reduce supply. In contrast, subsidies are “taxes in reverse.” If
the government subsidizes the production of a good, it in effect lowers the produc-
ers’ costs and increases supply.

PRICES OF OTHER GOODS

Firms that produce a particular product, say, soccer balls, can sometimes use their
plant and equipment to produce alternative goods, say, basketballs and volleyballs.
The higher prices of these “other goods” may entice soccer ball producers to switch
production to those other goods in order to increase profits. This substitution in pro-
duction results in a decline in the supply of soccer balls. Alternatively, when the
prices of basketballs and volleyballs decline relative to the price of soccer balls, pro-
ducers of those goods may decide to produce more soccer balls instead, increasing
their supply.

PRICE EXPECTATIONS
Changes in expectations about the future price of a product may affect the producer’s
current willingness to supply that product. It is difficult, however, to generalize
about how a new expectation of higher prices affects the present supply of a prod-
uct. Farmers anticipating a higher corn price in the future might withhold some of
their current corn harvest from the market, thereby causing a decrease in the current
supply of corn. Similarly, if people suddenly expect that the price of Nortel stock will
rise significantly in the near future, the supply offered for sale today might decrease.
In contrast, in many types of manufacturing industries, newly formed expectations
that price will increase may induce firms to add another shift of workers or to expand
their production facilities, causing current supply to increase.

NUMBER OF SELLERS
Other things equal, the larger the number of suppliers, the greater the market supply.
As more firms enter an industry, the supply curve shifts to the right. Conversely, the
smaller the number of firms in the industry, the less the market supply. This means
that as firms leave an industry, the supply curve shifts to the left. Example: Canada
and the United States have imposed restrictions on haddock fishing to replenish
dwindling stocks. As part of that policy, the federal government has bought the boats
of some of the haddock fishermen as a way of putting them out of business and
decreasing the catch. The result has been a decline in the market supply of haddock.
Table 3-7 is a checklist of the determinants of supply, along with further illustra-
tions. (Key Question 5)
 chapter three • individual markets: demand and supply 61

TABLE 3-7 DETERMINANTS OF SUPPLY: FACTORS THAT SHIFT

THE SUPPLY CURVE
Determinant Examples

Change in resource prices
Change in technology
Changes in taxes and subsidies
Change in prices of other goods
Change in expectations
Change in number of suppliers
A decrease in the price of microchips increases the supply of
computers; an increase in the price of crude oil reduces the supply
of gasoline.
The development of more effective wireless technology increases
the supply of cell phones.
An increase in the excise tax on cigarettes reduces the supply of
cigarettes; a decline in subsidies to universities reduces the supply
of higher education.
An increase in the price of cucumbers decreases the supply of
watermelons.
An expectation of a substantial rise in future log prices decreases
the supply of logs today.
An increase in the number of Internet service providers increases
the supply of such services; the formation of women’s professional
basketball leagues increases the supply of women’s professional
basketball games.

Changes in Quantity Supplied

change in
supply A The distinction between a change in supply and a change in quantity supplied parallels
change in the quan- the distinction between a change in demand and a change in quantity demanded.
tity supplied of a Because supply is a schedule or curve, a change in supply means a change in the
good or service at entire schedule and a shift of the entire curve. An increase in supply shifts the curve
every price; a shift
to the right; a decrease in supply shifts it to the left. The cause of a change in sup-
of the supply curve
to the left or right. ply is a change in one or more of the determinants of supply.
In contrast, a change in quantity supplied is a movement from one point to
change in another on a fixed supply curve. The cause of such a movement is a change in the
quantity price of the specific product being considered. In Table 3-6, a decline in the price of
supplied A corn from $5 to $4 decreases the quantity of corn supplied per week from 12,000 to
movement from
one point to 10,000 bushels. This is a change in quantity supplied, not a change in supply. Sup-
another on a fixed ply is the full schedule of prices and quantities shown, and this schedule does not change
supply curve. when price changes.

● A supply schedule or curve shows that, other
things equal, the quantity of a good supplied
varies directly with its price.
● The supply curve shifts because of changes in
(a) resource prices, (b) technology, (c) taxes or
subsidies, (d) prices of other goods, (e) expec-
tations of future prices, and (f) the number of
suppliers.
● A change in supply is a shift of the supply curve;
a change in quantity supplied is a movement
from one point to another on a fixed supply
curve.
62 Part One • An Introduction to Economics and the Economy

Supply and Demand: Market Equilibrium

We can now bring together supply and demand
TABLE 3-8 MARKET SUPPLY to see how the buying decisions of households
OF AND DEMAND and the selling decisions of businesses interact
FOR CORN to determine the price of a product and the
quantity actually bought and sold. In Table 3-8,
(1) (2) (3) (4)
Total Price Total Surplus (+) columns 1 and 2 repeat the market supply of
quantity per quantity or corn (from Table 3-6), and columns 2 and 3
supplied bushel demanded shortage (–) repeat the market demand for corn (from Table
per week per week 3-3). We assume that this is a competitive mar-
ket—neither buyers nor sellers can set the price.
12,000 $5 2,000 +10,000↓
10,000 4 4,000 + 6,000↓
7,000 3 7,000 0
Surpluses
4,000 2 11,000 – 7,000↑ We have limited our example to only five pos-
sible prices. Of these, which will actually pre-
1,000 1 16,000 –15,000↑
vail as the market price for corn? We can find an
The arrows indicate the effect on price. answer through trial and error. For no particu-
lar reason, let’s start with $5. We see immedi-
ately that this cannot be the prevailing market
price. At the $5 price, producers are willing to produce and offer for sale 12,000
bushels of corn, but buyers are willing to buy only 2000 bushels. The $5 price
encourages farmers to produce lots of corn but discourages most consumers from
surplus The buying it. The result is a 10,000-bushel surplus or excess supply of corn. This surplus,
amount by which shown in column 4 of Table 3-8, is the excess of quantity supplied over quantity
the quantity sup- demanded at $5. Corn farmers would find themselves with 10,000 unsold bushels
plied of a product
exceeds the quan-
of output.
tity demanded at a A price of $5, even if it existed temporarily in the corn market, could not persist
specific (above- over a period of time. The very large surplus of corn would drive competing sellers
equilibrium) price. to lower the price to encourage buyers to take the surplus off their hands.
Suppose the price goes down to $4. The lower price encourages consumers to buy
The more corn and, at the same time, induces farmers to offer less of it for sale. The sur-
Effectiveness
of Markets plus diminishes to 6000 bushels. Nevertheless, since there is still a surplus, compe-
tition among sellers will once again reduce the price. Clearly, then, the prices of $5
and $4 will not survive because they are “too high.” The market price of corn must
be less than $4.

Shortages
Let’s jump now to $1 as the possible market price of corn. Observe in column 4 of
Table 3-8 that at this price, quantity demanded exceeds quantity supplied by 15,000
units. The $1 price discourages farmers from devoting resources to corn production
and encourages consumers to attempt to buy more than is available. The result is a
shortage 15,000-bushel shortage of, or excess demand for, corn. The $1 price cannot persist as
The amount by the market price. Many consumers who want to buy at this price will not get corn.
which the quantity They will express a willingness to pay more than $1 to get some of the available out-
demanded of a
product exceeds the
put. Competition among these buyers will drive up the price to something greater
quantity supplied at than $1.
a particular (below- Suppose the competition among buyers boosts the price to $2. This higher price
equilibrium) price. will reduce, but will not eliminate, the shortage of corn. For $2, farmers devote more
 chapter three • individual markets: demand and supply 63

resources to corn production, and some buyers who were willing to pay $1 per
bushel will not want to buy corn at $2. But a shortage of 7000 bushels still exists at
$2. This shortage will push the market price above $2.

Equilibrium Price and Quantity

By trial and error we have eliminated every price but $3. At $3, and only at this price,
the quantity of corn that farmers are willing to produce and supply is identical with
the quantity consumers are willing and able to buy. There is neither a shortage nor
a surplus of corn at that price.
With no shortage or surplus at $3, there is no reason for the price of corn to change.
equilibrium Economists call this price the market-clearing or equilibrium price, equilibrium
price The price meaning “in balance” or “at rest.” At $3, quantity supplied and quantity demanded
in a competitive are in balance at the equilibrium quantity of 7000 bushels. So $3 is the only stable
market at which the
quantity demanded
price of corn under the supply and demand conditions shown in Table 3-8.
and the quantity The price of corn, or of any other product bought and sold in competitive mar-
supplied are equal. kets, will be established where the supply decisions of producers and the demand
decisions of buyers are mutually consistent. Such decisions are consistent only at the
equilibrium equilibrium price (here, $3) and equilibrium quantity (here, 7000 bushels). At any
quantity The higher price, suppliers want to sell more than consumers want to buy and a surplus
quantity demanded
and supplied at results; at any lower price, consumers want to buy more than producers make avail-
the equilibrium able for sale and a shortage results. Such discrepancies between the supply and
price in a competi- demand intentions of sellers and buyers then prompt price changes that bring the
tive market. two sets of intentions into accord.
A graphical analysis of supply and demand should yield these same conclusions.
Figure 3-5 (Key Graph) shows the market supply and demand curves for corn on
the same graph. (The horizontal axis now measures both quantity demanded and
quantity supplied.)
Graphically, the intersection of the supply curve and the demand curve for a product indi-
cates the market equilibrium. Here, equilibrium price and quantity are $3 per bushel
and 7000 bushels. At any above-equilibrium price, quantity supplied exceeds quan-
tity demanded. This surplus of corn causes price reductions by sellers who are
eager to rid themselves of their surplus. The falling price causes less corn to be
offered and simultaneously encourages consumers to buy more. The market moves
to its equilibrium.
Any price below the equilibrium price creates a shortage; quantity demanded
rationing then exceeds quantity supplied. Buyers try to obtain the product by offering to pay
function of more for it; this drives the price upward toward its equilibrium level. The rising
prices The abil- price simultaneously causes producers to increase the quantity supplied and
ity of market forces prompts many buyers to leave the market, thus eliminating the shortage. Again the
in a competitive market moves to its equilibrium.
market to equalize
quantity demanded
and quantity sup- Rationing Function of Prices
plied and to elimi-
nate shortages via The ability of the competitive forces of supply and demand to establish a price at
changes in prices. which selling and buying decisions are consistent is called the rationing function
of prices. In our case, the equilibrium price of $3 clears the market, leaving no bur-
densome surplus for sellers and no inconvenient shortage for potential buyers. And
it is the combination of freely made individual decisions that sets this market-
clearing price. In effect, the market outcome says that all buyers who are willing and
able to pay $3 for a bushel of corn will obtain it; all buyers who can not or will not
64 Part One • An Introduction to Economics and the Economy

Key Graph FIGURE 3-5 EQUILIBRIUM PRICE AND QUANTITY

P
The intersection of the downsloping $6
demand curve D and the upsloping S
supply curve S indicates the equi-
5 6000-bushel
librium price and quantity, here $3 surplus
and 7000 bushels of corn. The short-

Price (per bushel)

ages of corn at below-equilibrium
prices (for example, 7000 bushels 4
at $2), drive up price. These higher
prices increase the quantity sup-
3
plied and reduce the quantity
demanded until equilibrium is
achieved. The surpluses caused by
2
above-equilibrium prices (for exam-
ple, 6000 bushels at $4), push price 7000-bushel
down. As price drops, the quantity 1 shortage
demanded rises and the quantity D
supplied falls until equilibrium is
established. At the equilibrium Q
price and quantity, there are neither 0 2 4 6 7 8 10 12 14 16 18
shortages nor surpluses of corn. Bushels of corn (thousands per week)

Quick Quiz
1. Demand curve D is downsloping because:
a. producers offer less product for sale as the price of the product falls.
b. lower prices of a product create income and substitution effects, which lead
consumers to purchase more of it.
c. the larger the number of buyers in a market, the lower the product price.
d. price and quantity demanded are directly (positively) related.
2. Supply curve S:
a. reflects an inverse (negative) relationship between price and quantity supplied.
b. reflects a direct (positive) relationship between price and quantity supplied.
c. depicts the collective behaviour of buyers in this market.
d. shows that producers will offer more of a product for sale at a low product
price than at a high product price.
3. At the $3 price
a. quantity supplied exceeds quantity demanded.
b. quantity demanded exceeds quantity supplied.
c. the product is abundant and a surplus exists.
d. there is no pressure on price to rise or fall.
4. At price $5 in this market:
a. there will be a shortage of 10,000 units
b. there will be a surplus of 10,000 units.
c. quantity demanded will be 12,000 units
d. quantity demanded will equal quantity supplied.
Answers:
1. b; 2. b; 3. d; 4. b
 chapter three • individual markets: demand and supply 65

pay $3 will go without corn. Similarly, all producers who are willing and able to
offer corn for sale at $3 a bushel will sell it; all producers who can not or will not sell
for $3 per bushel will not sell their product. (Key Question 7)

Changes in Supply, Demand, and Equilibrium

We know that demand might change because of fluctuations in consumer tastes or
incomes, changes in consumer expectations, or variations in the prices of related
goods. Supply might change in response to changes in resource prices, technology,
or taxes. What effects will such changes in supply and demand have on equilibrium
price and quantity?

CHANGES IN DEMAND
Suppose that supply is constant and demand increases, as shown in Figure 3-6(a).
As a result, the new intersection of the supply and demand curves is at higher val-
ues on both the price and quantity axes. An increase in demand raises both equilib-
rium price and equilibrium quantity. Conversely, a decrease in demand, such as that
shown in Figure 3-6(b), reduces both equilibrium price and equilibrium quantity.
(The value of graphical analysis is now apparent: We need not fumble with columns
of figures to determine the outcomes; we need only compare the new and the old
points of intersection on the graph.)

CHANGES IN SUPPLY
Now suppose that demand is constant but supply increases, as in Figure 3-6(c). The
new intersection of supply and demand is located at a lower equilibrium price but
at a higher equilibrium quantity. An increase in supply reduces equilibrium price
but increases equilibrium quantity. In contrast, if supply decreases, as in Figure
3-6(d), the equilibrium price rises while the equilibrium quantity declines.

COMPLEX CASES
When both supply and demand change, the effect is a combination of the individ-
ual effects.
1. Supply Increase; Demand Decrease What effect will a supply increase and a
demand decrease have on equilibrium price? Both changes decrease price, so the
net result is a price drop greater than that resulting from either change alone.
What about equilibrium quantity? Here the effects of the changes in supply
and demand are opposed: The increase in supply increases equilibrium quantity,
but the decrease in demand reduces it. The direction of the change in quantity
depends on the relative sizes of the changes in supply and demand. If the
increase in supply is larger than the decrease in demand, the equilibrium quan-
tity will increase. But if the decrease in demand is greater than the increase in
supply, the equilibrium quantity will decrease.
2. Supply Decrease; Demand Increase A decrease in supply and an increase in
demand both increase price. Their combined effect is an increase in equilibrium
price greater than that caused by either change separately. But their effect on
equilibrium quantity is again indeterminate, depending on the relative sizes of
the changes in supply and demand. If the decrease in supply is larger than the
increase in demand, the equilibrium quantity will decrease. In contrast, if the
increase in demand is greater than the decrease in supply, the equilibrium quan-
tity will increase.
66 Part One • An Introduction to Economics and the Economy

FIGURE 3-6 CHANGES IN DEMAND AND SUPPLY AND THE

EFFECTS ON PRICE AND QUANTITY
P P
S S
D ↑: P ↑ , Q ↑ D ↓: P ↓ , Q ↓

D1

D2

D1 D2

Q Q
0 0

(a) Increase in demand (b) Decrease in demand

P P
S1 S2 S2 S1
S ↑: P ↓ , Q ↑ S ↓: P ↑ , Q ↓

D D

Q Q
0 0

(c) Increase in supply (d) Decrease in supply

The increase in demand from D1 to D2 in (a) increases both equilibrium price and quantity. The decrease in demand from D1 to
D2 in (b) decreases both equilibrium price and quantity. The increase in supply from S1 to S2 in (c) decreases equilibrium price
and increases equilibrium quantity. The decline in supply from S1 to S2 in (d) increases equilibrium price and decreases equi-
librium quantity. The boxes in the top right corners summarize the respective changes and outcomes. The upward arrows in
those boxes signify increases in demand (D), supply (S), equilibrium price (P), and equilibrium quantity (Q); the downward
arrows signify decreases in these items.

3. Supply Increase; Demand Increase What if supply and demand both increase?
A supply increase drops equilibrium price, while a demand increase boosts it. If
the increase in supply is greater than the increase in demand, the equilibrium
price will fall. If the opposite holds, the equilibrium price will rise.
The effect on equilibrium quantity is certain: The increases in supply and in
demand each raise equilibrium quantity. Therefore, the equilibrium quantity will
increase by an amount greater than that caused by either change alone.
4. Supply Decrease; Demand Decrease What about decreases in both supply
and demand? If the decrease in supply is greater than the decrease in demand,
 chapter three • individual markets: demand and supply 67

equilibrium price will rise. If the reverse is

TABLE 3-9 EFFECTS OF true, equilibrium price will fall. Because
CHANGES IN decreases in supply and in demand each
BOTH SUPPLY reduce equilibrium quantity, we can be sure
AND DEMAND that equilibrium quantity will fall.
Effect on Effect on Table 3-9 summarizes these four cases. To
Change in Change in equilibrium equilibrium understand them fully you should draw supply
supply demand price quantity and demand diagrams for each case to confirm
1 Increase Decrease Decrease Indeterminate the effects listed in Table 3-9.
Special cases arise when a decrease in de-
2 Decrease Increase Increase Indeterminate
mand and a decrease in supply, or an increase
3 Increase Increase Indeterminate Increase
in demand and an increase in supply, exactly
4 Decrease Decrease Indeterminate Decrease cancel out. In both cases, the net effect on equi-
librium price will be zero; price will not change.
(Key Question 8)

A Reminder: “Other Things Equal”

We must stress once again that specific demand and supply curves (such as those in
Figure 3-6) show relationships between prices and quantities demanded and sup-
plied, other things equal. The downsloping demand curves tell us that price and quan-
tity demanded are inversely related, other things equal. The upsloping supply curves
imply that price and quantity supplied are directly related, other things equal.
If you forget the other-things-equal assumption, you can encounter situations
that seem to be in conflict with these basic principles. For example, suppose salsa
manufacturers sell one million bottles of salsa at $4 a bottle in one year, two million
bottles at $5 in the next year; and three million at $6 in the year thereafter. Price and
quantity purchased vary directly, and these data seem to be at odds with the law of
demand. But there is no conflict here; these data do not refute the law of demand.
The catch is that the law of demand’s other-things-equal assumption has been vio-
lated over the three years in the example. Specifically, because of changing tastes
and rising incomes, the demand for salsa has increased sharply, as in Figure 3-6a.
The result is higher prices and larger quantities purchased.
Another example: The price of coffee occasionally has shot upward at the same
time that the quantity of coffee produced has declined. These events seemingly con-
tradict the direct relationship between price and quantity denoted by supply. The
catch again is that the other-things-equal assumption underlying the upsloping sup-
ply curve was violated. Poor coffee harvests decreased supply, as in Figure 3-6d,
increasing the equilibrium price of coffee and reducing the equilibrium quantity.
These examples emphasize the importance of our earlier distinction between a
change in quantity demanded (or supplied) and a change in demand (supply). In
Figure 3-6a a change in demand causes a change in the quantity supplied. In Figure
3-6d a change in supply causes a change in quantity demanded.

Application: Pink Salmon

To reinforce these ideas, let’s briefly examine a real-world market: the market for
pink salmon. This market has a standardized product, for which price has substan-
tially declined in recent years.
A decade or two ago, fishers earned a relatively high price for each kilogram of
pink salmon brought to the dock. That price is represented as P1 in Figure 3-7 at the
68 Part One • An Introduction to Economics and the Economy

FIGURE 3-7 THE MARKET FOR PINK SALMON

In the last two decades, P S1
the supply of pink P1
salmon has increased

Price (per kilogram)

S2
and the demand for pink
salmon has decreased.
As a result, the price
of pink salmon has
declined, here from P1
to P2 a kilogram. Since
supply has increased
more than demand has D1
P2
declined, the equilibrium
quantity of pink salmon D2
has increased, here from
Q1 to Q2. 0 Q1 Q2 Q
Quantity (kilograms)

intersection of supply curve S1 and demand curve D1. The corresponding quantity
of pink salmon—the type used mainly for canning—is represented as Q1 pounds.
Over the past few decades, supply and demand shifted in the market for pink
salmon. On the supply side, improved technology in the form of larger, more effi-
cient fishing boats greatly increased the catch and lowered the cost of obtaining it.
Also, high profits at price P1 encouraged many new fishers to enter the industry. As
a result of these changes, the supply of pink salmon greatly increased and the sup-
ply curve shifted to the right, as from S1 to S2 in Figure 3-7.
Over the same years, the demand for pink salmon decreased, as represented by
the leftward shift from D1 to D2 in Figure 3-7. That decrease resulted from increases
in consumer income and reductions in the price of substitute products. As buyers’
incomes increased, they shifted demand away from canned fish and toward higher-
quality fresh or frozen fish, including higher-quality species of salmon such as
Atlantic, Chinook, and Coho salmon. Moreover, the emergence of fish farming, in
which salmon are raised in net pens, lowered the prices of these substitute species.
That, too, reduced the demand for pink salmon.
The decreased supply of, and demand for, pink salmon greatly reduced the price
of pink salmon, as represented by the drop from P1 to P2 in Figure 3-7. Both the sup-
ply increase and the decrease helped reduce the equilibrium price. However, the
equilibrium quantity of pink salmon increased, as represented by the move from Q1
to Q2. Both shifts of the curve reduced the equilibrium price, but equilibrium quan-
tity increased because the increase in supply exceeded the decrease in demand.
 chapter three • individual markets: demand and supply 69

● In competitive markets, prices adjust to the
equilibrium level at which quantity demanded
equals quantity supplied.
● The equilibrium price and quantity are those
indicated by the intersection of the supply and
demand curves for any product or resource.
● An increase in demand increases equilibrium
price and quantity; a decrease in demand de-
creases equilibrium price and quantity.
● An increase in supply reduces equilibrium price
but increases equilibrium quantity; a decrease in
supply increases equilibrium price but reduces
equilibrium quantity.
● Over time, equilibrium price and quantity may
change in directions that seem at odds with the
laws of demand and supply because the other-
things-equal assumption is violated.

TICKET SCALPING: A BUM RAP?

The
Effectiveness
of Markets
Tickets to athletic and artistic
events are sometimes resold at
higher-than-original prices—a
market transaction known by the
term “scalping.” For example,
the original buyer may resell a
$50 ticket to an NHL game for
$200, $250, or more. The media
often denounce scalpers for
“ripping off” buyers by charging
“exorbitant” prices. Scalping and
extortion are synonymous in
some people’s minds.
But is scalping really sinful?
We must first recognize that
such ticket resales are voluntary
transactions. Both buyer and
seller expect to gain from the ex-
change. Otherwise it would not
occur! The seller must value
the $200 more than seeing the
event, and the buyer must value
seeing the event more than the
Some market transactions get a bad name that is not
warranted.
$200. So there are no losers or
victims here: Both buyer and
seller benefit from the transac-
tion. The “scalping” market sim-
ply redistributes assets (game or
concert tickets) from those who
value them less to those who
value them more.
Does scalping impose losses
or injury on other parties, in par-
ticular the event sponsors of the
event? If the sponsors are in-
jured, it is because they initially
priced tickets below the equilib-
rium level. In so doing they suf-
fer an economic loss in the form
of less revenue and profit than
they might have otherwise re-
ceived. But the loss is self-
inflicted because of their pricing
error. That mistake is quite sepa-
rate and distinct from the fact
that some tickets were later sold
at a higher price.
What about spectators? Does
scalping deteriorate the enthu-
siasm of the audience? No! Peo-
ple who have the greatest inter-
est in the event will pay the
scalper’s high prices. Ticket
scalping also benefits the teams
and performing artists, because
they will appear before more
dedicated audiences—ones that
are more likely to buy souvenir
items or CDs.
So, is ticket scalping undesir-
able? Not on economic grounds.
Both seller and buyer of a
“scalped” ticket benefit, and a
more interested audience re-
sults. Event sponsors may sacri-
fice revenue and profits, but that
stems from their own misjudg-
ment of the equilibrium price.
70 Part One • An Introduction to Economics and the Economy

chapter summary
1. A market is an institution or arrangement that
brings together buyers and sellers of a prod-
uct, service, or resource for the purpose of
exchange.
2. Demand is a schedule or curve representing
the willingness of buyers in a specific period
to purchase a particular product at each of
various prices. The law of demand implies
that consumers will buy more of a product at
a low price than at a high price. Therefore,
other things equal, the relationship between
price and quantity demanded is negative or
inverse and is graphed as a downsloping
curve. Market demand curves are found by
adding horizontally the demand curves of the
many individual consumers in the market.
3. Changes in one or more of the determinants
of demand (consumer tastes, the number of
buyers in the market, the money incomes of
consumers, the prices of related goods, and
price expectations) shift the market demand
curve. A shift to the right is an increase in
demand; a shift to the left is a decrease in
demand. A change in demand is different
from a change in the quantity demanded, the
latter being a movement from one point
to another point on a fixed demand curve
because of a change in the product’s price.
4. Supply is a schedule or curve showing the
amounts of a product that producers are will-
ing to offer in the market at each possible price
during a specific period. The law of supply
states that, other things equal, producers will
offer more of a product at a high price than at
a low price. Thus, the relationship between
price and quantity supplied is positive or
direct, and supply is graphed as an upsloping
curve. The market supply curve is the horizon-
tal summation of the supply curves of the indi-
vidual producers of the product.
5. Changes in one or more of the determinants of
supply (resource prices, production techniques,
taxes or subsidies, the prices of other goods,
price expectations, or the number of sellers in
the market) shift the supply curve of a product.
A shift to the right is an increase in supply; a
shift to the left is a decrease in supply. In con-
trast, a change in the price of the product being
considered causes a change in the quantity sup-
plied, which is shown as a movement from one
point to another point on a fixed supply curve.
6. The equilibrium price and quantity are estab-
lished at the intersection of the supply and
demand curves. The interaction of market
demand and market supply adjusts the price
to the point at which the quantity demanded
and supplied are equal. This is the equilibrium
price. The corresponding quantity is the equi-
librium quantity.
7. The ability of market forces to synchronize
selling and buying decisions to eliminate
potential surpluses and shortages is known as
the rationing function of prices.
8. A change in either demand or supply changes
the equilibrium price and quantity. Increases
in demand raise both equilibrium price and
equilibrium quantity; decreases in demand
lower both equilibrium price and equilibrium
quantity. Increases in supply lower equilib-
rium price and raise equilibrium quantity;
decreases in supply raise equilibrium price
and lower equilibrium quantity.
9. Simultaneous changes in demand and supply
affect equilibrium price and quantity in vari-
ous ways, depending on their direction and
relative magnitudes.

terms and concepts

change in demand, p. 57
change in quantity
demanded, p. 57
change in quantity supplied,
p. 61
change in supply, p. 61
complementary goods, p. 55
demand, p. 50
demand curve, p. 52
demand schedule, p. 50
determinants of demand, p. 53
determinants of supply, p. 58
equilibrium price, p. 63
equilibrium quantity, p. 63
income effect, p. 51
inferior good, p. 55
law of demand, p. 51
law of supply, p. 58
marginal utility, p. 51
market, p. 50
normal good, p. 55
rationing function of prices,
p. 63
shortage, p. 62
substitute goods, p. 55
substitution effect, p. 51
supply, p. 57
supply curve, p. 58
supply schedule, p. 57
surplus, p. 62
 chapter three • individual markets: demand and supply 71

study questions
1. Explain the law of demand. Why does a
demand curve slope downward? What are
the determinants of demand? What happens
to the demand curve when each of these
determinants changes? Distinguish between
a change in demand and a change in the
quantity demanded, noting the cause(s) of
each.
e. A decline in the price of product A, a
good whose production requires sub-
stantially the same techniques and re-
sources as does the production of B.
f. The levying of a specific sales tax on B.
g. The granting of a 50-cent per-unit subsidy
for each unit of B produced.

2. KEY QUESTION What effect will each 6. “In the corn market, demand often exceeds
of the following have on the demand for supply and supply sometimes exceeds
product B? demand.” “The price of corn rises and
falls in response to changes in supply and
a. Product B becomes more fashionable. demand.” In which of these two statements
b. The price of substitute product C falls. are the terms supply and demand used cor-
rectly? Explain.
c. Income declines and product B is an infe-
rior good. 7. KEY QUESTION Suppose the total
demand for wheat and the total supply of
d. Consumers anticipate the price of B will wheat per month in the Winnipeg grain mar-
be lower in the near future. ket are as follows:
e. The price of complementary product D
falls. Thousands Thousands Surplus (+)
of bushels Price per of bushels or
f. Foreign tariff barriers on product B are demanded bushel supplied shortage (–)
eliminated.
85 $3.40 72 __________
3. Explain the following news dispatch from
Hull, England: “The fish market here 80 $3.70 73 __________
slumped today to what local commentators 75 $4.00 75 __________
called ‘a disastrous level’—all because of a 70 $4.30 77 __________
shortage of potatoes. The potatoes are one
of the main ingredients in a dish that figures 65 $4.60 79 __________
on almost every café-menu—fish and chips.” 60 $4.90 81 __________
4. Explain the law of supply. Why does the sup-
ply curve slope upward? What are the deter- a. What is the equilibrium price? What is the
minants of supply? What happens to the equilibrium quantity? Fill in the surplus–
supply curve when each of these determi- shortage column and use it to explain
nants changes? Distinguish between a change why your answers are correct.
in supply and a change in the quantity sup-
b. Graph the demand for wheat and the sup-
plied, nothing the cause(s) of each.
ply of wheat. Be sure to label the axes of
5. KEY QUESTION What effect will each your graph correctly. Label equilibrium
of the following have on the supply of prod- price P and equilibrium quantity Q.
uct B? c. Why will $3.40 not be the equilibrium
a. A technological advance in the methods price in this market? Why not $4.90?
of producing product B. “Surpluses drive prices up; shortages
drive them down.” Do you agree?
b. A decline in the number of firms in indus-
try B. d. Now suppose that the government estab-
lishes a ceiling (legal maximum) price of,
c. An increase in the prices of resources
say, $3.70 for wheat. Explain carefully the
required in the production of B.
effects of this ceiling price. Demonstrate
d. The expectation that the equilibrium price your answer graphically. What might
of B will be lower in the future than it is prompt government to establish a ceiling
currently. price?
72 Part One • An Introduction to Economics and the Economy
8. KEY QUESTION How will each of the
following changes in demand and/or supply
affect equilibrium price and equilibrium
quantity in a competitive market; that is,
do price and quantity rise, fall, or remain
unchanged, or are the answers indetermi-
nate because they depend on the magni-
tudes of the shifts? Use supply and demand
diagrams to verify your answers.
a. Supply decreases and demand is con-
stant.
b. Demand decreases and supply is con-
stant.
c. Supply increases and demand is con-
stant.
d. Demand increases and supply increases.
e. Demand increases and supply is con-
stant.
f. Supply increases and demand decreases.
g. Demand increases and supply decreases.
h. Demand decreases and supply decreases.
9. “Prices are the automatic regulator that
tends to keep production and consumption
in line with each other.” Explain.
10. Explain: “Even though parking meters may
yield little or no revenue, they should never-
internet application question
1. Changes in Demand—Baby Diapers and
Retirement Villages Other things equal, an
increase in the number of buyers for a prod-
uct or service will increase demand. Baby
diapers and retirement villages are two
products designed for different population
groups. The U.S. Census www.census.gov/
ipc/www/idbpyr.html provides population
pyramids (graphs that show the distribution
of population by age and sex) for countries
theless be retained because of the rationing
function they perform.”
11. Critically evaluate: “In comparing the two
equilibrium positions in Figure 3-6a, I note
that a larger amount is actually purchased at a
higher price. This refutes the law of demand.”
12. Suppose you go to a recycling centre and are
paid $.25 per kilogram for your aluminum
cans. However, the recycling firm charges
you $.20 per bundle to accept your old news-
papers. Use demand and supply diagrams to
portray both markets. Explain how different
government policies with respect to the
recycling of aluminum and paper might
account for these different market outcomes.
13. Advanced analysis: Assume that demand for
a commodity is represented by the equation
P = 10 – .2Q d and supply by the equation P =
2 + .2Q s , where Q d and Q s are quantity
demanded and quantity supplied, respec-
tively, and P is price. Using the equilibrium
condition Q s = Q d, solve the equations to
determine equilibrium price. Now determine
equilibrium quantity. Graph the two equa-
tions to substantiate your answers.
14. (Last Word) Discuss the economic aspects
of ticket scalping, specifying gainers and
losers.
for the current year, 2025, and 2050. View the
population pyramids for Mexico, Japan, and
Canada. Which country would you expect to
have the greatest percentage increase in
demand for baby diapers in the year 2050?
For retirement villages? Which country
would you expect to have the greatest
absolute increase in demand for baby dia-
pers? For retirement villages?
 chapter three • individual markets: demand and supply 73

Appendix to
Chapter 3

The Mathematics of Market Equilibrium

A market equilibrium is the price and the quantity, denoted as the pair (Q*, P*), of a
commodity bought or sold at price P*. The following mathematical note provides an
introduction of how a market equilibrium (Q*, P*) is derived.
The market equilibrium is found by using the market demand (buyers’ behaviour),
the market supply (sellers’ behaviour), and the negotiating process (to find the agreed
upon price and quantity, namely P* and Q*, on which to transact). The market equi-
librium is identified by the condition reached at the end of the negotiating process that
at the price they negotiated, P*, the quantity of the commodity that buyers are will-
ing to buy, denoted as QD, and the quantity sellers are willing to sell, denoted as QS,
matches exactly.
The equation describing the downward sloping demand, in which QD represents
the quantity demanded by buyers and P the price, is
P = a – bQd
The demand tells us that if the price is higher than a then the buyers will not buy; thus,
for a transaction to occur the price must be lower. The demand also tells us that at a
price lower than a the quantity demanded by the buyers increases. Buyers’ behaviour,
as described by the demand equation, is that at lower prices buyers buy more quantity.
The equation describing the upward sloping market supply function, in which QS
represents the quantity supplied by sellers and P the price is
P = c + dQs
For the sellers if the price is lower than c then they will sell nothing. If the price is c
or higher, then the supply equation states that sellers facing higher prices sell more
quantity. Sellers’ behaviour, as described by the supply equation, is that at higher
prices sellers sell more quantity.
The negotiating process (in which price and quantity or both adjust) provides the
mechanism by which, eventually, buyers and sellers agree upon a price, P*, and a
quantity, Q*, at which they can buy and sell and thus complete the transaction. At the
end of the negotiating process, the quantity demanded by the buyers, QD, is equal to
the quantity supplied by the sellers, QS (at the agreed-upon price), and thus the mar-
ket is in equilibrium. The mathematical representation of such a negotiating process
is described in the following paragraphs.
At the agreed price, P*, the equilibrium condition of the negotiating process, the
equality in the quantity demanded and supplied, is
Dd = QS
74 Part One • An Introduction to Economics and the Economy

Having denoted Q* as the equilibrium quantity, then it must be that Q* = Qd = Qs.

To solve for the equilibrium quantity Q* and the equilibrium price P* the demand
and supply functions are used. With Q* the equilibrium quantity, for the buyers
P* = a – bQ*,
and for the sellers
P* = c + dQ*.
Now, since P* is the same agreed-upon price by both buyer and seller, then
a – bQ* = c + dQ*,
giving the equilibrium quantity, Q*, as
Q* = (a – c)/(b + d).
To find P* substitute (a – c)/(b + d) in the supply (or demand) function.
P* = c + d(a – c)/(b + d), thus
P* = (ad + bc)/(a + d).
The equilibrium is (Q*, P*) = [(a – c)/(b + d), (ad + cb)/(a + d)].
The market equilibrium may also be represented diagrammatically, as shown in
Figure A3-1.

FIGURE A3-1

P
Equilibrium
[(a – c)/(b + d ) (ad + cb)/(b + d )]
a Supply
P = c + dQ

P*

Demand
P = a – bQ
c

Q* Q
• Increase (decrease) in demand, a increases (decreases)
and both Q* and P* increase (decrease)
• Increase (decrease) in supply, c decreases (increases) and
Q* increases (decreases) and P* decreases (increases)
 FOUR

An Overview
of the Market
System and
the Canadian
Economy

S
IN THIS CHAPTER uppose that you were assigned to com-
Y OU WILL LEARN: pile a list of all the individual goods and

The basic institutions required services available at a large shopping

for a market economy.
• mall, including the different brands and vari-
The Four Fundamental
Questions any economy faces. ations of each type of product. We think you
•
How the “invisible hand” helps would agree that this task would be daunting
to close the gap between
private and public interests. and the list would be long! And, although a
•
single shopping mall contains a remarkable
The role of government
in a market economy. quantity and variety of goods, it is only a
•
About the structure of the miniscule part of the national economy.
Canadian economy.
76 Part One • An Introduction to Economics and the Economy

Who decided that the particular goods and services available at the mall and in the
broader economy should be produced? How did the producers determine which
technology and types of resources to use in producing these particular goods? Who
will obtain these products? What accounts for the new and improved products
among these goods?
In Chapter 3 we saw how equilibrium prices and quantities are established in
individual product and resource markets. We now widen our focus to take in all
product markets and resource markets—capitalism, also called the private enterprise
system or simply the market system. In this chapter we examine the characteristics of
the market system and how it answers questions such as those posed above.

Characteristics of the Market System

The
A market brings together buyers and sellers. It can be a local market in which rela-
Effectiveness tively few people participate, or it can be on an international scale where buyers and
of Markets
sellers from all over the globe participate. In order for the market system to func-
tion several notable characteristics must be present: private property, freedom of
enterprise and choice, self-interest as the dominant motive, competition, and a lim-
ited role for government.

Private Property
In a market system, private individuals and firms, not the government, own most
of the property resources (land and capital). In fact, it is this extensive private own-
private ership of capital that gives capitalism its name. This right of private property, cou-
property pled with the freedom to negotiate binding legal contracts, enables individuals and
The right of private businesses to obtain, use, and dispose of property resources as they see fit. The right
persons and firms
to obtain, own,
of property owners to designate who will receive their property when they die sus-
control, employ, tains the institution of private property.
dispose of, and Property rights encourage investment, innovation, exchange, maintenance of
bequeath land, property, and the expansion of the production of goods and services. Almost every-
capital, and other one can see that individuals stock stores, build factories, or clear land for farming
property.
because they can reap the rewards. Why would they do so if the government, or
anyone else, could take that property from them?
Property rights also extend to the intellectual property through patents, copy-
rights, and trademarks. Such long-term protection encourages people to write
books, music, and computer programs and to invent new products and production
processes without fear that others will steal them and the rewards they may bring.
Property rights also facilitate exchange. The title to an automobile or the deed to
a cattle ranch assures the buyer that the seller is the legitimate owner. Moreover,
property rights encourage owners to maintain or improve their property so as to
preserve or increase its value. Finally, property rights enable people to use their time
and resources to produce more goods and services, rather than using them to pro-
tect and retain the property they have already produced or acquired.

Freedom of Enterprise and Choice

Closely related to private ownership of property is freedom of enterprise and
choice. The market system requires that various economic units make choices,
which are expressed and implemented in the economy’s markets.
 chapter four • an overview of the market system and the canadian economy 77

freedom of ● Freedom of enterprise ensures that entrepreneurs and private businesses are
enterprise free to obtain and use resources to produce their choice of goods and services,
The freedom of and to sell them in the markets of their choice.
firms to obtain eco-
nomic resources, to ● Freedom of choice allows owners to employ or dispose of their property and
use these resources money as they see fit. It also allows workers to enter any line of work for which
to produce products
of the firm’s own
they are qualified. Finally, it ensures that consumers are free to buy the goods
choosing, and to and services that best satisfy their wants.
sell their products
in markets of their
These choices are free only within broad legal limitations, of course. Illegal
choice. choices such as selling human organs or buying illicit drugs are punished through
fines and imprisonment. (Global Perspective 4.1 reveals that the degree of economic
freedom of freedom varies greatly from nation to nation.)
choice The
freedom of owners
of property Self-Interest
resources to
employ or dispose
In the market system, self-interest is the motivating force of all the various eco-
of them as they see nomic units as they express their free choices. Self-interest means that each eco-
fit, of workers to nomic unit tries to do what is best for itself. Entrepreneurs try to maximize profit or
enter any line of minimize loss. Property owners try to get the highest price for the sale or rent of
work for which they their resources. Workers try to maximize their utility (satisfaction) by finding jobs
are qualified, and of
consumers to spend
that offer the best combination of wages, hours, fringe benefits, and working con-
their incomes in a ditions. Consumers try to obtain the products they want at the lowest possible price
manner that they and apportion their expenditures to maximize their utility.
think is appropriate.

self-
interest
That which each 4.1
firm, property
owner, worker,
and consumer FREE
believes is best Index of Economic
1 Hong Kong
for itself and seeks Freedom, Selected
to obtain. Nations 4 New Zealand
5 United States
The Index of Economic
MOSTLY FREE
Freedom measures economic
13 Chile
freedom using 10 broad
categories, such as trade 14 Canada
policy, property rights, and 20 Germany
government intervention, MOSTLY UNFREE
with each category containing 75 Malaysia
more than 50 specific criteria. 93 Brazil
The Index then ranks 157 106 Poland
nations according to the REPRESSED
degree of economic freedom.
144 Vietnam
A few selected rankings for
151 Iran
2000 are listed here.
152 Cuba
Source: Heritage Foundation and the Wall Street Journal.
78 Part One • An Introduction to Economics and the Economy

The pursuit of self-interest is not the same as selfishness. Self-interest simply

means maximizing some benefit, and can include helping others. A stockholder may
invest to receive the best available corporate dividends and then donate a portion
of them to the United Way or give them to grandchildren. A worker may take a sec-
ond job to help pay college or university tuition for her or his children. An entre-
preneur may make a fortune and donate much of it to a charitable foundation. For
example, Ted Turner, the entrepreneur who started CNN, donated one billion U.S.
dollars to the United Nations!

Competition
competition The market system fosters competition among economic units. The basis of this
The presence in a competition is freedom of choice exercised in pursuit of the best return. Very
market of a large broadly defined, competition requires:
number of inde-
pendent buyers and ● Independently acting sellers and buyers operating in a particular product or
sellers competing resource market
with one another
and the freedom of ● Freedom of sellers and buyers to enter or leave markets, based on their self-
buyers and sellers interest
to enter and leave
the market. Competition diffuses economic power within the businesses and households that
make up the economy. When there are independently acting sellers and buyers in a
market, no one buyer or seller is able to dictate the price of the product.
Consider the supply side of the product market. When a product becomes scarce,
its price rises. An unseasonable frost in Florida may seriously reduce the supply of
citrus crops and sharply increase the price of oranges. Similarly, if a single producer
can somehow restrict the total output of a product, it can raise the product’s price.
By controlling market supply, a firm can “rig the market” to its own advantage. But
that is not possible in markets in which suppliers compete. A firm that raises its
price will lose part or all of its business to competitors.
The same reasoning applies to the demand side of the market. Because there are
multiple buyers, single buyers cannot manipulate the market to their own advan-
tage by refusing to pay the market price.
Competition also implies that producers can enter or leave an industry; there are
no insurmountable barriers to an industry expanding or contracting. This freedom
of an industry to expand or contract provides the economy with the flexibility
needed to remain efficient over time. Freedom of entry and exit enables the econ-
omy to adjust to changes in consumer tastes, technology, and resource availability.
The diffusion of economic power inherent in competition limits the potential abuse of that
power. A producer who charges more than the competitive market price will lose
sales to other producers. An employer who pays less than the competitive market
wage will lose workers to other employers. A firm that fails to exploit new technol-
ogy will lose profits to firms that do. Competition is the basic regulatory force in the
market system.

Markets and Prices

Markets and prices are key characteristics of the market system. They give the sys-
tem its ability to coordinate millions of daily economic decisions. We know from
Chapters 2 and 3 that a market is a mechanism that brings buyers (demanders) and
sellers (suppliers) into contact. A market system is necessary to convey the decisions
made by buyers and sellers of products and resources. The decisions made on each
 chapter four • an overview of the market system and the canadian economy 79

side of the market determine a set of product and resource prices that guide
resource owners, entrepreneurs, and consumers as they make and revise their free
choices and pursue their self-interest.
The market system itself is an organizing mechanism. It serves as an elaborate
communication network through which innumerable individual free choices are
recorded, summarized, and balanced. Those who respond to market signals and
obey market dictates are rewarded with greater profit and income; those who do not
respond to these signals and choose to ignore market dictates are penalized.
Through this mechanism society decides what the economy should produce, how
production can be organized efficiently, and how the fruits of production are to be
distributed among the various units that make up the economy.

Active but Limited Government

The final characteristic of the market system, as evidenced in modern economies, is
an active but limited government. Although a market system promotes a high
degree of efficiency in the use of its resources, it has certain shortcomings. We will
discover later in this chapter that government can increase the overall effectiveness
of the economic system in several ways.

● The market system requires private ownership
of property, freedom of enterprise, freedom of
choice, and limited government.
● The market system permits economic entities—
business, resource suppliers, and consumers—
to pursue and further their self-interest. It pre-
vents any single economic entity from dictating
the prices of products or resources.
● The coordinating mechanism of the market sys-
tem is a system of markets and prices.

Technology and Capital Goods

The market system fosters the extensive use of capital goods. In the market system,
competition, freedom of choice, self-interest, and personal reward provide the
opportunity and motivation for technological advance. The monetary rewards for
new products or production techniques accrue directly to the innovator. The mar-
ket system therefore encourages extensive use and rapid development of complex
roundabout capital goods: tools, machinery, large-scale factories, and facilities for storage, com-
production munication, transportation, and marketing.
The construction Advanced technology and capital goods are important because the most direct
and use of capital to
aid in the produc-
methods of production are the least efficient. The only way to avoid that inefficiency
tion of consumer is to rely on roundabout production. It would be ridiculous for a farmer to go at
goods. production with bare hands. There are huge benefits—in the form of more efficient
production and, therefore, a more abundant output—to be derived from creating
specializa- and using such tools of production (capital equipment) as plows, tractors, storage
tion The use bins, and so on.
of the resources of
an individual, a
firm, a region, or a Specialization
nation to produce
one or a few goods The extent to which market economies rely on specialization is extraordinary. The
and services. majority of consumers produce virtually none of the goods and services they
80 Part One • An Introduction to Economics and the Economy

consume, and they consume little or nothing of what they produce. The worker
who devotes eight hours a day to installing windows in Fords may own a Honda.
Many farmers sell their milk to the local dairy and then buy margarine at the local
grocery store. Society learned long ago that self-sufficiency breeds inefficiency. The
jack-of-all-trades may be a very colourful individual but is certainly not an efficient
producer.

DIVISION OF LABOUR
division of Human specialization—called the division of labour—contributes to a society’s
labour Divid- output in several ways.
ing the work
required to produce ● Specialization makes use of differences in ability. Specialization enables
a product into a individuals to take advantage of existing differences in their abilities and
number of different skills. If caveman A is strong and swift, and good at tracking animals, and
tasks that are per-
formed by different
caveman B is weak and slow but patient, their distribution of talents can be
workers. most efficiently used if A hunts and B fishes.
● Specialization fosters learning by doing. Even if the abilities of A and B are
identical, specialization may still be advantageous. By devoting all your time
to a single task, you are more likely to develop the skills it requires and to
devise improved techniques than you would by working at a number of dif-
ferent tasks. You learn to be a good hunter by going hunting every day.
● Specialization saves time. By devoting all your time to a single task you
avoid the loss of time incurred in shifting from one job to another.
For all these reasons, specialization increases the total output society derives
from limited resources.

GEOGRAPHIC SPECIALIZATION
Specialization also works on a regional and international basis. It is conceivable that
apples could be grown in Saskatchewan, but because of the unsuitability of the land,
rainfall, and temperature, the costs would be very high. And it is conceivable that
wheat could be grown in British Columbia. But for similar reasons such production
would be costly. So, Saskatchewan farmers produce products—wheat in particu-
lar—for which their resources are best suited, and British Columbians (in the
Okanagan Valley) do the same, producing apples and other fruits. By specializing,
both economies produce more than is needed locally. Then, very sensibly, they swap
some of their surpluses—wheat for apples, apples for wheat.
Similarly, on an international scale, Canada specializes in producing such items
as telecommunication equipment and small commercial aircraft, which it sells
medium of abroad in exchange for video recorders from Japan, bananas from Honduras, and
exchange woven baskets from Thailand. Both human specialization and geographical spe-
Items sellers gener-
ally accept and buy- cialization are needed to achieve efficiency in the use of limited resources.
ers generally use to
pay for a good or
service.
Use of Money
Specialization and trade require the extensive use of money. Money performs several
barter The functions, but first and foremost it is a medium of exchange. It makes trade easier.
exchange of one
good or service for
A convenient means of exchanging goods is required for specialization. Exchange can,
another good or and sometimes does, occur through barter—swapping goods for goods, say, wheat
service. for apples. But barter poses serious problems for the economy because it requires a
 chapter four • an overview of the market system and the canadian economy 81

FIGURE 4-1 MONEY FACILITATES TRADE WHEN WANTS DO

NOT COINCIDE
The use of money as a
medium of exchange Saskatchewan
permits trade to be
accomplished despite Has surplus
a non-coincidence of of wheat.
wants. (1) Saskatchewan Wants potatoes.
trades the wheat that
B.C. wants for money;

(1)
y
ne
(2) Saskatchewan trades

Mo
Mo
the money it receives

(1)

ne
oe
(2)
from B.C. for the pota-

y
tat

Wh
toes it wants from P.E.I.;

Po

e
(3) P.E.I. trades the

at
(2)
money it receives from
Saskatchewan for the Prince Edward British Columbia
apples it wants from B.C. (3) Apples
Island
Has surplus
Has surplus of apples.
of potatoes. Wants wheat.
Wants apples. (3) Money

coincidence of wants between the buyer and seller. In our example, we assumed that
Saskatchewan had excess wheat to trade and wanted apples. And we assumed that
British Columbia had excess apples to trade and wanted wheat. So an exchange
occurred. But if such a coincidence of wants is missing, trade cannot occur.
Suppose Saskatchewan has no interest in British Columbia’s apples but wants
potatoes from Prince Edward Island. And suppose that Prince Edward Island wants
www.swp.com
British Columbia’s apples but not Saskatchewan’s wheat. And, to complicate mat-
Saskatchewan ters, suppose that British Columbia wants some of Saskatchewan’s wheat but none
Wheat Pool of PEI’s potatoes. We summarize the situation in Figure 4-1.
In none of these cases shown in the figure is there a coincidence of wants, thus
trade by barter clearly would be difficult. Instead, people in each province use
money Any item money, which is simply a convenient social invention to facilitate exchanges of
that is generally goods and services. Historically, people have used cattle, cigarettes, shells, stones,
acceptable to sellers pieces of metal, and many other commodities, with varying degrees of success, as a
in exchange for
goods and services.
medium of exchange. But to serve as money, an item needs to pass only one test: It
must be generally acceptable to sellers in exchange for their goods and services. Money is
socially defined; whatever society accepts as a medium of exchange is money.
Most economies use pieces of paper as money. The use of paper dollars (cur-
rency) as a medium of exchange is what enables Saskatchewan, B.C., and P.E.I. to
overcome their trade stalemate, as demonstrated in Figure 4-1.
On a global basis the fact that different nations have different currencies compli-
cates specialization and exchange. However, markets in which currencies are
bought and sold make it possible for residents of Canada, Japan, Germany, Britain,
and Mexico, through the swapping of dollars, yen, euros, pounds, and pesos, one
for another, to exchange goods and services.
82 Part One • An Introduction to Economics and the Economy

● The market systems of modern industrial
economies facilitate the extensive use of tech-
nologically advanced capital goods. Such goods
help these economies achieve greater efficiency
in production.
● Specialization is extensive in market systems; it
enhances efficiency and output by enabling
individuals, regions, and nations to produce
those goods and services for which their re-
sources are best suited.
● The use of money in market systems facilitates
the exchange of goods and services that spe-
cialization requires.

The Market System at Work

household There are two primary decision makers in a market economy: households (con-
An economic unit sumers) and firms (businesses). Households are the ultimate suppliers of economic
(of one or more resources and simultaneously the major spending group in the economy. Firms pro-
persons) that pro-
vides the economy
vide goods and services to the economy.
with resources and We have noted that a market system is characterized by competition, freedom of
uses the income enterprise, and choice. Consumers are free to buy what they choose; entrepreneurs
received to pur- and firms are free to produce and sell what they choose; and resource suppliers are
chase goods and free to make their property and human resources available in whatever use or occu-
services that satisfy
material wants.
pation they choose. We may wonder why such an economy does not collapse in
chaos. If consumers want breakfast cereal but businesses choose to produce aerobic
firm An organiza- shoes and resource suppliers decide to manufacture computer software, production
tion that employs would seem to be deadlocked by the apparent inconsistency of these free choices.
resources to pro- In reality, the millions of decisions made by households and businesses are highly
duce a good or
service for profit.
consistent with one another. Firms do produce the goods and services that consumers
want, and households do provide the kinds of labour that businesses want.
To understand the operation of the market system, you must first recognize that
Four Fun- every economy must respond to Four Fundamental Questions:
damental
Questions ● What goods and services will be produced?
The four questions
that every economy
● How will the goods and services be produced?
must answer. ● Who will get the goods and services?
● How will the system accommodate change?
The Four Fundamental Questions highlight the economic choices underlying the
production possibilities curve discussed in Chapter 2. Let’s examine how the market
system answers each of these questions and thus addresses the economic problem.

What Will Be Produced?

With product and resource prices in place, established through competition in both
the product and resource markets, how will the market system decide on the spe-
cific types and quantities of goods to be produced? Because businesses seek profits and
avoid losses, those goods and services produced at a continuing profit will be produced and
those produced at a continuing loss will not. Profits and losses depend on the difference
 chapter four • an overview of the market system and the canadian economy 83

between the total revenue a firm receives from selling its product and the total cost
of producing the product.
Consumers register their preferences on the demand side of the product market;
producers and resource suppliers respond appropriately in seeking to further their
own self-interests. The market system communicates the wants of consumers to
businesses and resource suppliers and elicits appropriate responses.

CONSUMER SOVEREIGNTY AND “DOLLAR VOTES”

consumer In the market system, consumers are sovereign (in command). Consumer sover-
sovereignty eignty works through consumer demand, and consumer demand is crucial in deter-
Determination by mining the types and quantities of goods produced. Consumers spend the income
consumers of the
types and quantities
they earn from the sale of their resources on those goods they are most willing and
of goods and serv- able to buy. Through these dollar votes consumers register their wants via the
ices that will be demand side of the product market. If the dollar votes for a certain product are great
produced with the enough to provide a normal profit, businesses will produce that product. If there is
scarce resources an increase in consumer demand, so that enough dollar votes are cast to provide an
of the economy.
economic profit, the industry will expand, as will the output of the product.
dollar Conversely, a decrease in consumer demand—meaning fewer dollar votes cast
votes The for the product—will result in losses, and, in time, the industry will contract. As
“votes” that con- firms leave the industry, the output of the product will decline. Indeed, the indus-
sumers and entre- try may even cease to exist. Again, the consumers are sovereign; they collectively
preneurs cast for
the production of
direct resources away from industries that are not meeting consumer wants.
consumer and capi- The dollar votes of consumers determine not only which industries will continue
tal goods, respec- to exist but also which products will survive or fail. Example: In 1991, responding
tively, when they to doctors and nutritionists, McDonald’s introduced its low-fat McLean burger.
purchase them in Good idea? Not really. Most consumers found the new product “too dry” and “not
product and
resource markets.
tasty,” so sales were meagre. In 1996 McDonald’s quietly dropped the McLean
burger from its menu at the same time that it introduced its higher-fat Arch Deluxe
burger. In effect, consumers had collectively “voted out” the McLean burger.

MARKET RESTRAINTS ON FREEDOM

Firms are not really free to produce whatever they wish. Consumers’ buying deci-
sions make the production of some products profitable and the production of other
products unprofitable, thus restricting the choice of firms in deciding what to pro-
duce. Firms must match their production choices with consumer choices or else face
losses and eventual bankruptcy.
The same holds true for resource suppliers. The demand for resources is a
derived derived demand—derived, that is, from the demand for the goods and services that
demand The the resources help produce. There is a demand for autoworkers because there is a
demand for a demand for automobiles. There is no demand for buggy-whip braiders because
resource that
depends on the
there is no demand for buggy whips. Resource suppliers are not free to allocate their
demand for the resources to the production of goods that consumers do not value highly. Con-
products it can be sumers register their preferences on the demand side of the product market, pro-
used to produce. ducers and resource suppliers, prompted by their own self-interest, respond
appropriately.

How Will the Goods and Services Be Produced?

The market system steers resources to those industries that have products con-
sumers want—simply because those industries survive, are profitable, and pay for
84 Part One • An Introduction to Economics and the Economy

resources. Within each industry, the firms that survive are the ones that are prof-
itable. Because competition weeds out high-cost producers, continued profitabil-
ity requires that firms produce their output at minimum cost. Achieving least-cost
production necessitates, among other things, that firms locate their production
facilities optimally, taking into consideration such factors as resource prices,
resource productivity, and transportation costs.
Least-cost production also means that firms must employ the most economically
efficient technique of production in producing their output. The most efficient pro-
duction technique depends on:
● The available technology
● The prices of the needed resources
A technique that requires just a few inputs of resources to produce a specific amount
may be highly inefficient economically if those resources are valued very highly in
the market. Economic efficiency means obtaining a particular output of product with the
least input of scarce resources, when both output and resource inputs are measured in dol-
lars and cents.

Who Will Get the Goods and Services?

The market system enters the picture in two ways when solving the problem of dis-
tributing total output. Generally, any product will be distributed to consumers
based on their ability and willingness to pay its existing market price. If the price of
some product, say, a pocket calculator, is $15, then those buyers who are able and
willing to pay that price will get a pocket calculator. This is the rationing function
of equilibrium prices.
The ability to pay the equilibrium prices for pocket calculators and other prod-
ucts depends on the amount of income that consumers earn. If they earn sufficient
income and want to spend their money on a particular good, they can have it. The
amount of income they earn depends on (1) the quantities of the property and
human resources they supply and (2) the prices those resources command in the
resource market. This in turn is dependent on the demand for the items produced
with those resources. Resource prices (wages, interest, rent, profit) are key in deter-
mining the size of each household’s income and therefore each household’s ability
to buy part of the economy’s output.

How Will the System Accommodate Change?

Market systems are dynamic: Consumer preferences, technology, and supplies of
resources constantly change. A particular allocation of resources that is now the
most efficient for a specific pattern of consumer tastes, range of technological alter-
natives, and supplies of resources may become obsolete and inefficient as consumer
preferences change, new techniques of production are discovered, and resource sup-
plies change over time. Can the market economy adjust to such changes and still use
resources efficiently?

GUIDING FUNCTION OF PRICES

Suppose consumer tastes change. For instance, assume that consumers decide they
want more fruit juice and less milk than the economy currently provides. Those
changes in consumer tastes will be communicated to producers through an increase
 chapter four • an overview of the market system and the canadian economy 85

in demand for fruit and a decline in demand for milk. Fruit prices will rise and milk
prices will fall.
Now, assuming that firms in both industries were enjoying profits before these
changes in consumer demand set in, the higher fruit prices will mean higher profit
for the fruit industry, and the lower milk prices will mean losses for the milk indus-
try. Self-interest will induce new competitors to enter the prosperous fruit industry
and will in time force firms to leave the depressed milk industry.
The higher profit that initially follows the increase in demand for fruit will
not only induce that industry to expand but will also give it the revenue needed
to obtain the resources essential to its growth. Higher fruit prices will permit
fruit producers to pay higher prices for resources, thereby increasing resource
demand and drawing resources from less urgent alternative employment. The
reverse occurs in the milk industry, where resources demand declines and fewer
workers and other resources are employed. These adjustments in the economy are
appropriate responses to the changes in consumer tastes. This is consumer sover-
eignty at work.
The market system is a gigantic communications system. Through changes in
prices it communicates changes in such basic matters as consumer tastes and elicits
appropriate responses from businesses and resource suppliers. By affecting product
prices and profits, changes in consumer tastes direct the expansion of some indus-
tries and the contraction of others. Those adjustments are conveyed to the resource
market as expanding industries demand more resources and contracting industries
demand fewer; the resulting changes in resource prices guide resources from the
contracting industries to the expanding industries.
guiding This directing or guiding function of prices is a core element of the market sys-
function of tem. Without such a system, some administrative agency, such as a government
prices The abil- planning board, would have to direct businesses and resources into the appropriate
ity of price changes
to bring about
industries. A similar analysis shows that the system can and does adjust to other
changes in the fundamental changes—for example, to changes in technology and in the availabil-
quantities of prod- ity of various resources.
ucts and resources
demanded and ROLE IN PROMOTING PROGRESS
supplied.
Adjusting to changes is one thing; initiating desirable changes is another. How does
the market system promote technological improvements and capital accumula-
tion—two changes that lead to greater productivity and a higher level of material
well-being for society?

Technological Advance The market system provides a strong incentive for techno-
logical advance and enables better products and processes to brush aside inferior ones.
An entrepreneur or firm that introduces a popular new product will gain profit. Tech-
nological advance also includes new and improved methods that reduce production
or distribution costs. By passing part of its cost reduction on to the consumer through
creative a lower product price, the firm can increase sales and obtain economic profit at the
destruction
The hypothesis that expense of rival firms. Moreover, the market system is conducive to the rapid spread of
the creation of new technological advance throughout an industry. Rival firms must follow the lead of the
products and pro- most innovative firm or else suffer immediate losses and eventual failure. In some
duction methods cases, the result is creative destruction: The creation of new products and production
simultaneously
destroys the market
methods completely destroys the market positions of firms that are wedded to exist-
power of existing ing products and older ways of doing business. Example: The advent of personal com-
monopolies. puters and word processing software demolished the market for electric typewriters.
86 Part One • An Introduction to Economics and the Economy

Capital Accumulation Most technological advances require additional capital

goods. The market system provides the resources necessary to produce those goods
by adjusting the product market and the resource market through increased dollar
votes for capital goods.
But who will register votes for capital goods? Entrepreneurs and owners of busi-
nesses often use part of their profit income to purchase capital goods. Doing so
yields even greater profit income in the future if the technological innovation is suc-
cessful. Also, by paying interest or selling ownership shares, the entrepreneur and
firm can attract some of the income of households to cast dollar votes for the pro-
duction of more capital goods. (Key Question 8)

Competition and the “Invisible Hand”

In his 1776 book The Wealth of Nations, Adam Smith first noted that the operation of
a market system creates a curious unity between private interests and social inter-
ests. Firms and resource suppliers, seeking to further their own self-interest and
operating within the framework of a highly competitive market system, will simul-
invisible taneously, as though guided by an “invisible hand,” promote the public or social
hand The ten- interest. In a competitive environment, businesses use the least-costly combination
dency of firms and of resources to produce a specific output because it is in their self-interest to do so.
resource suppliers
seeking to further
To act otherwise would be to forgo profit or even to risk business failure. But, at the
their own self- same time, to use scarce resources in the least-costly (most efficient) way is also in
interests in com- the public interest.
petitive markets to In our more-fruit-juice-less-milk illustration, it is self-interest that induces
also promote the responses appropriate to the change in society’s wants. Businesses seeking to make
interests of society
as a whole.
higher profits and to avoid losses, and resource suppliers pursuing greater mone-
tary rewards, negotiate changes in the allocation of resources and end up with the
The
output that society demands. Competition controls or guides self-interest in such a
Effectiveness way that it automatically, and quite unintentionally, furthers the best interests of
of Markets society. The “invisible hand” ensures us that when firms maximize their profits, they
also maximize society’s output and income.
Of the many virtues of the market system, three merit special emphasis:
● Efficiency The basic economic argument for the market system is that it pro-
motes the efficient use of resources, by guiding them into the production of those
goods and services most wanted by society. It forces the use of the most efficient
techniques in organizing resources for production, and it encourages the devel-
opment and adoption of new and more efficient production techniques.
● Incentives The market system encourages skill acquisition, hard work, and
innovation. Greater work skills and effort mean greater production and higher
incomes, which translate into a higher standard of living. Similarly, the assum-
ing of risks by entrepreneurs can result in substantial profit incomes. Success-
ful innovations generate economic rewards.
● Freedom The major non-economic argument for the market system is its
emphasis on personal freedom. In contrast to central planning, the market sys-
tem coordinates economic activity without coercion. The market system per-
mits—indeed, it thrives on—freedom of enterprise and choice. Entrepreneurs
and workers are free to further their own self-interest, subject to the rewards
and penalties imposed by the market system itself.
 chapter four • an overview of the market system and the canadian economy 87

● The output mix of the market system is deter-
mined by profits, which in turn depend heavily
on consumer preferences. Profits cause effi-
cient industries to expand; losses cause ineffi-
cient industries to contract.
● Competition forces industries to use the least-
costly (most efficient) production methods.
● In a market economy, consumer income and
product prices determine how output will be
distributed.
● Competitive markets reallocate resources in
response to changes in consumer tastes, tech-
nological advances, and changes in supplies of
resources.
● The “invisible hand” of the market system
channels the pursuit of self-interest to the good
of society.

Market Failure
The market system has many positive aspects in its favour. Unfortunately, there are
The Role of
Governments instances when it doesn’t work. Market failure occurs when the competitive market
system (1) produces the “wrong” amounts of certain goods and services or (2) fails
to allocate any resources whatsoever to the production of certain goods and serv-
ices that are economically justified. The first type of failure results from what econ-
omists call spillovers, and the second type involves public goods. Both kinds of market
failure can be corrected by government action.

Spillovers or Externalities
When we say that competitive markets automatically bring about the efficient use
of resources, we assume that all the benefits and costs for each product are fully
reflected in the market demand and supply curves. That is not always the case. In
some markets certain benefits or costs may escape the buyer or seller.
A spillover occurs when some of the costs or the benefits of a good are passed on
to or “spill over to” someone other than the immediate buyer or seller. Spillovers are
also called externalities because they are benefits or costs that accrue to some third
party that is external to the market transaction.

SPILLOVER COSTS
Production or consumption costs inflicted on a third party without compensation
spillover are called spillover costs. Environmental pollution is an example. When a chemical
costs A cost manufacturer or a meatpacking plant dumps its wastes into a lake or river, swim-
imposed without mers, fishers, and boaters—and perhaps those who drink the water—suffer spill-
compensation on
third parties by the
over costs. When a petroleum refinery pollutes the air with smoke or a paper mill
production or con- creates obnoxious odours, the community experiences spillover costs for which it is
sumption of sellers not compensated.
or buyers. What are the economic effects? Recall that costs determine the position of the
firm’s supply curve. When a firm avoids some costs by polluting, its supply curve
lies farther to the right than it does when the firm bears the full costs of production.
As a result, the price of the product is too low and the output of the product is too
large to achieve allocative efficiency. A market failure occurs in the form of an over-
allocation of resources to the production of the good.
88 Part One • An Introduction to Economics and the Economy

CORRECTING FOR SPILLOVER COSTS

Government can do two things to correct the overallocation of resources. Both solu-
tions are designed to internalize external costs—that is, to make the offending firm
pay the costs rather than shift them to others:
● Legislation In cases of air and water pollution, the most direct action is leg-
islation prohibiting or limiting the pollution. Such legislation forces potential
polluters to pay for the proper disposal of industrial wastes—here, by
installing smoke-abatement equipment or water-purification facilities. The
idea is to force potential offenders, under the threat of legal action, to bear all
the costs associated with production.
● Specific taxes A less direct action is based on the fact that taxes are a cost and
therefore a determinant of a firm’s supply curve. Government might levy a
specific tax—that is, a tax confined to a particular product—on each unit of the
polluting firm’s output. The amount of this tax would roughly equal the esti-
mated amount of the spillover cost arising from the production of each unit of
output. Through this tax, government would pass back to the offending firm
a cost equivalent to the spillover cost the firm is avoiding. This would shift the
firm’s supply curve to the left, reducing equilibrium output and eliminating
the overallocation of resources.

SPILLOVER BENEFITS
Sometimes spillovers appear as benefits. The production or consumption of certain
goods and services may confer spillover or external benefits on third parties or on
the community at large without compensating payment. Immunization against
measles and polio results in direct benefits to the immediate consumer of those vac-
cines. But it also results in widespread substantial spillover benefits to the entire
community.
spillover Education is another example of spillover benefits. Education benefits individ-
benefit A ben- ual consumers: “Better-educated” people generally achieve higher incomes than
efit obtained with- “less-well-educated” people. But education also provides benefits to society, in the
out compensation
by third parties form of a more versatile and more productive labour force, on the one hand, and
from the production smaller outlays for crime prevention, law enforcement, and welfare programs, on
or consumption of the other.
sellers or buyers. Spillover benefits mean that the market demand curve, which reflects only pri-
vate benefits, understates total benefits. The demand curve for the product lies far-
ther to the left than it would if the market took all benefits into account. As a result,
a smaller amount of the product will be produced or, alternatively, there will be an
underallocation of resources to the product—again a market failure.

CORRECTING FOR SPILLOVER BENEFITS

How might the underallocation of resources associated with spillover benefits
be corrected? The answer is either to subsidize consumers (to increase demand), to
subsidize producers (to increase supply), or, in the extreme, to have government
produce the product.
● Subsidize consumers To correct the underallocation of resources to higher
education, the federal and provincial governments provide low-interest loans
to students so that they can afford more education. Those loans increase the
demand for higher education.
 chapter four • an overview of the market system and the canadian economy 89

● Subsidize suppliers In some cases government finds it more convenient and

administratively simpler to correct an underallocation by subsidizing suppli-
ers. For example, in higher education, provincial governments provide sub-
stantial portions of the budgets of colleges and universities. Such subsidies
lower the costs of producing higher education and increase its supply. Publicly
subsidized immunization programs, hospitals, and medical research are other
examples.
● Provide goods via government A third policy option may be appropriate
where spillover benefits are extremely large: Government may finance or, in
the extreme, own and operate the industry that is involved.

Public Goods and Services

Certain goods called private goods are goods produced through the competitive mar-
ket system and are said to be divisible because they are produced in units small
enough to be purchased and used by individual buyers. Examples are the many
exclusion items sold in stores. Private goods are also subject to the exclusion principle. Buy-
principle The ers who are willing and able to pay the price of the product obtain it, but those
ability to exclude who are unable or unwilling to pay are excluded from acquiring the product and
those who do not
pay for a product its benefits.
from receiving its Certain other goods and services, called public goods, have the opposite charac-
benefits. teristics. Public goods are indivisible; they must be produced in such large units that
they cannot ordinarily be sold to individual buyers. Individuals can buy hamburg-
public good ers, computers, and automobiles through the market but they cannot buy aircraft
A good or service
that is indivisible carriers, highways, or space telescopes.
and to which the The exclusion principle does not apply to public goods since there is no effective way
exclusion principle of excluding individuals from their benefits once such goods come into existence.
does not apply. Obtaining the benefits of private goods requires that they be purchased; obtaining the
benefits of pubic goods requires only that they be available.
The classic example of a public good is a proposed lighthouse on a treacherous
free-rider coast. The construction of the lighthouse would be economically justified if its ben-
problem The efits (fewer shipwrecks) exceeded its cost. But the benefits accruing to a single user
inability of potential
providers of an eco- would not be great enough to justify the purchase of such an indivisible product.
nomically desirable Moreover, once it was in operation, the warning light would be a guide to all ships;
but indivisible good there would be no practical way to exclude any captain from using the light. Econ-
or service to obtain omists call this the free-rider problem, in which people receive benefits from a good
payment from
those who benefit,
without contributing to its cost.
because the exclu- Because the services of the lighthouse cannot be priced and sold, it would be
sion principle is not unprofitable for a private firm to devote resources to it. So here we have a service
applicable. that could yield substantial benefits but to which the market system would allocate
no resources. It is a public good, much like national defence, flood control, and pub-
quasi-public lic health. Society signals its desire for such goods by voting for particular political
good A good or
service to which the candidates who support their provision. The goods themselves must be provided by
exclusion principle the public sector and financed by compulsory charges in the form of taxes.
could apply, but
that has such a
large spillover Quasi-Public Goods
benefit that govern- Government provides many goods that fit the economist’s definition of a public
ment sponsors its
production to pre- good. However, it also provides other goods and services that could be produced
vent an underallo- and delivered in such a way that the exclusion principle would apply. Such goods,
cation of resources. called quasi-public goods, include education, streets and highways, police and
90 Part One • An Introduction to Economics and the Economy

fire protection, libraries and museums, preventive medicine, and sewage dis-
posal. They could all be priced and provided by private firms through the market
system. But, as we noted earlier, because they all have substantial spillover bene-
fits, they would be underproduced by the market system. Therefore, government
often provides them to avoid the underallocation of resources that would other-
wise occur.

The Reallocation Process

How are resources reallocated from the production of private goods to the produc-
tion of public and quasi-public goods? If the resources of the economy are fully
employed, government must free up resources from the production of private goods
and make them available for the production of public and quasi-public goods. It does
so by reducing private demand for them. And it does that by levying taxes on house-
holds and businesses, taking some of their income out of the circular flow. With lower
incomes and hence less purchasing power, households and businesses are obliged to
curtail their consumption and investment spending. As a result, the private demand
for goods and services declines, as does the private demand for resources. So by
diverting purchasing power from private spenders to government, taxes remove
resources from private use. (Global Perspective 4.2 shows the extent to which vari-
ous countries divert labour from the private sector to the public sector.)
Government then spends the tax proceeds to provide public and quasi-public
goods and services. Taxation releases resources from the production of private
consumer goods (food, clothing, television sets) and private investments goods
(printing presses, boxcars, warehouses). Government shifts those resources to
the production of public and quasi-public goods (post offices, submarines,
parks), changing the composition of the economy’s total output. (Key Questions
11 and 12)

4.2

Government Employment
Government employment as Percentage of
as a percentage of total Total Employment, 1999
employment, selected 5 10 15 20 25 30 35
nations Sweden
Denmark
The ratio of government France
employment to total employ- Canada
ment measures the extent to Italy
which government diverts Germany
Switzerland
labour resources from the pri-
Netherlands
vate sector in order to produce United States
public goods and quasi-public Japan
goods. The ratio, or percentage,
varies greatly among nations.
Source: Organization for Economic Cooperation and Development.
 chapter four • an overview of the market system and the canadian economy 91

● Government can correct for the overallocation of
resources associated with spillover costs through
legislation or taxes; it can offset the underalloca-
tion of resources associated with spillover bene-
fits by granting government subsidies.
● Government provides certain public goods be-
cause they are indivisible and free-riders can
obtain them without payment; government also
provides many quasi-public goods because of
their large spillover benefits.

The Circular Flow Revisited

In Figure 4-2 we integrate government into the circular flow model first shown in
Figure 2-6. Here flows (1) through (4) are the same as the corresponding flows in
that figure. Flows (1) and (2) show business expenditures for the resources provided
by households. These expenditures are costs to businesses but represent wage, rent,
interest, and profit income to households. Flows (3) and (4) show household expen-
ditures for the goods and services produced by businesses.
Now consider what happens when we add government. Flows (5) through (8)
illustrate that government makes purchases in both product and resource markets.
Flows (5) and (6) represent government purchases of such products as paper, com-
puters, and military hardware from private businesses. Flows (7) and (8) represent

FIGURE 4-2 THE CIRCULAR FLOW AND THE PUBLIC SECTOR

Government buys
products from the (1) Costs (1) Money income (rent
product market and s, w
RESOURCE ag
employs resources (2) Land, labour, cap es
MARKETS ita

,i
from the resource l,

nt
(2) Resources entrepreneurial ab

ere
market to provide i l it
y

st,
public goods and

profits)
services to house-
holds and busi- (7) (8)
Expenditures Resources
nesses. Government
finances its expendi-
tures through the net (10) (9)
Goods and services Goods and services
tax revenues (taxes
minus transfer pay- BUSINESSES GOVERNMENT HOUSEHOLDS
ments) it receives
from households and Net taxes Net taxes
businesses. (11) (12)

(5) (6)
Expenditures Goods and
services

Go (4) es
o ds and services (4) Goods and s er vic
PRODUCT
es

MARKETS r
it u
pe nd
(3) Revenue (3) Consumptio n ex
92 Part One • An Introduction to Economics and the Economy

government purchases of resources. The federal government employs and pays

salaries to members of Parliament, the armed forces, lawyers, meat inspectors, and so
on. Provincial and municipal governments hire and pay teachers, bus drivers, police,
and firefighters. The federal government might also lease or purchase land to expand
a military base and a city might buy land on which to build a new elementary school.
Government then provides public goods and services to both households and
businesses as shown by flows (9) and (10). To finance those public goods and serv-
ices, businesses and households are required to pay taxes, as shown by flows (11)
and (12). These flows are labelled as net taxes to indicate that they also include
“taxes in reverse” in the form of transfer payments to households and subsidies to
businesses. Thus, flow (11) entails various subsidies to farmers, ship builders, and
airlines as well as income, sales, and excise taxes paid by businesses to government.
Most subsidies to business are “concealed” in the form of low-interest loans, loan
guarantees, tax concessions, or public facilities provided at prices below their cost.
Similarly, flow (12) includes both taxes collected by government directly from
households and transfer payments such as welfare payments and social insurance
benefits paid by the government.
We can use Figure 4-2 to review how government alters the distribution of
income, reallocates resources, and changes the level of economic activity. The struc-
ture of taxes and transfer payments significantly affects income distribution. In flow
(12), a tax structure that draws tax revenues primarily from well-to-do households,
combined with a system of transfer payments to low-income households, reduces
income inequality.
Flows (5) through (8) imply that government diverts goods and resources away
from private sector consumption or use and directs them to the public sector. This
resource reallocation is required to produce public goods and services.

The Structure of the Canadian Economy

and Its Evolution over Time
Table 4-1 sets out the contribution to Canadian domestic output (GDP) by each sec-
tor and industry. An economy consists of three main sectors: primary, secondary, and
tertiary. The primary sector consists of agriculture and natural resources, including
fishing and mining. The secondary sector includes manufacturing, construction,
transportation and communication, and the utilities. The tertiary, or service, sector
makes up the rest of the economy, and is now by far the largest part of the Canadian
economy.

Sectoral Shifts over Time

Sectors have been continually changing over time, as some have shrunk in size
while others have expanded. For example, the primary sector, and agriculture in
particular, has been shrinking since the onset of industrialization in the nineteenth
century. Table 4-2 shows the employment share of each sector and subsector. Agri-
culture’s employment has fallen from about a quarter of the labour force in 1947 to
under 3 percent in 2000. Manufacturing has also experienced a decline in employ-
ment share, but the decline is less pronounced. The service sector has done the
opposite—its employment share has more than doubled since World War II.
These intersectoral shifts occur primarily because of technological advance,
which brings about increases in productivity. For example, while there has been a
 chapter four • an overview of the market system and the canadian economy 93

TABLE 4-1 PRODUCTION SHARES BY SECTOR, SELECTED

YEARS 1870-2000
% OF GROSS DOMESTIC PRODUCT AT FACTOR COST
1870 1911 1926 1960 1970 1980 1986 2000

PRIMARY 46.2 39.4 23.4 10.4 8.3 11.2 10.0 5.8

Agriculture 34.3 30.8 18.1 4.9 3.3 3.3 3.3 1.9
Forestry* 9.9 4.6 1.3 1.3 0.8 0.9 0.7 0.3
Fishing and trapping 1.1 1.5 0.8 0.2 0.2 0.2 0.2 0.1
Mining, quarrying, oil wells 0.9 2.5 3.2 4.0 4.0 6.8 5.8 3.5
SECONDARY 22.6 29.7 38.7 44.8 41.4 38.3 36.7 35.4
Manufacturing na 18.8 21.7 26.4 23.3 20.6 19.5 18.2
Construction na 10.3 4.1 6.0 6.3 5.9 7.0 5.4
Transportation and communication na na ⎫ 9.6 8.9 8.3 7.3 8.5
⎪ 12.9
Electric power, gas, and ⎬
⎪
water utilities na 0.6 ⎭ 2.8 2.9 3.5 2.9 3.3
a a
TERTIARY 31.2 30.8 37.9 44.8 50.2 50.5 53.3 58.8
Trade (wholesale, retail) na na 11.6 12.8 12.4 11.0 11.7 12.8
Finance, insurance, real estate na na 10.0 11.6 11.3 11.3 14.1 16.1
Public administration, defence na na 3.4 6.9 7.3 7.4 7.2 6.0
Service na na 12.9 13.5 19.2 20.8 20.3 23.9
Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0
aIncludes income generated by the railway and telephone industries.
*Figure for Forestry calculated as a residual.
Source: Data for 1870 to 1986 from C. Green, Canadian Industrial Organization and Policy (Toronto: McGraw-Hill Ryerson Ltd., 1990),
p. 4. Data for 2000 calculated from Statistics Canada, www.statisticscanada.ca/english/Pgdb/Economy/Economic/econ41.htm.
Visit www.mcgrawhill.ca/college/mcconnell9 for data update.

continuous decline in agriculture’s employment share, it has come about because of

large increases in labour (and land) productivity. An increase in labour productiv-
ity means fewer people are needed in that sector, unless there is a huge increase in
demand for agricultural products. Since there is a limit to how much we can eat,
agricultural labour became redundant and had to find work in the other two sectors,
particularly in the secondary (manufacturing) sector.
Since World War II, the secondary sector has been losing employment share as
productivity in that sector rose. Manufacturing in particular has seen a significant
drop in its employment share. Table 4-1 shows manufacturing’s GDP share dropped
from 26 percent in 1960 to about 18 percent in 2000. Table 4-2 indicates that the
employment share of manufacturing has dropped steadily since 1947. From over a
quarter of the labour force, manufacturing now employs only about 15 percent.

Foreign Ownership
A distinguishing characteristic of the Canadian economy is that a high percentage
is foreign owned, particularly by Americans. The term foreign owned generally
means outright ownership of a firm or owning at least 51 percent of the stocks.
94 Part One • An Introduction to Economics and the Economy

TABLE 4-2 EMPLOYMENT SHARES (%) BY ECONOMIC SECTOR

AND INDUSTRY
1891a 1921a 1947 1960 1970 1980 1987 2000

PRIMARY 49 36 27.5 14.3 9.3 7.3 6.4 4.4

Agriculture 24.1 11.3 6.5 4.5 4.0 2.5
Forestry 1.2 1.1 0.9 0.7 0.6 ⎫
⎪
Fishing and trapping 0.7 0.4 0.3 0.3 0.3 ⎬ 1.9
⎪
Mining, quarrying, oil wells 1.5 1.5 1.6 1.8 1.5 ⎭
SECONDARY 31 34 40.3 40.7 37.5 34.0 30.4 26.7
Manufacturing 26.7 24.9 22.7 19.7 17.1 15.3
Construction 5.2 7.2 6.0 5.8 5.7 5.5
Transportation and communication 7.7 7.5 7.7 7.3 6.6 5.2
Public utilities 0.7 1.1 1.1 1.2 1.0 0.7
TERTIARY 20 30 32.1 45.0 53.2 58.7 63.2 68.9
Trade (wholesale, retail) 12.3 16.2 16.7 17.2 17.7 15.6
Finance, insurance, real estate 2.7 3.8 4.6 5.7 5.8 5.8
Community, business, personal services 25.7 28.9 32.9 42.4
(including health, education) ⎫ ⎫
⎬ 17.1 ⎬ 25.0
Public administration ⎭ ⎭ 6.2 6.9 6.8 5.1
Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0
a
Based on occupational data in which all clerical workers are allocated to the tertiary sector and all nonprimary sector labourers
are allocated to the secondary sector.
Source: Data for 1891 to 1987 from C. Green, op. cit. (Toronto: McGraw-Hill Ryerson Ltd., 1990), p. 6. Data for 2000 calculated from
Statistics Canada, www.statisticscanada.ca/english/Pgdb/Economy/Economic/econ40.htm.
Visit www.mcgrawhill.ca/college/mcconnell9 for data update.

Foreign ownership has costs and benefits. But given the difficulties of measuring
costs and benefits, it is not surprising that the issue of foreign ownership often
arouses strong emotions. Perhaps the most serious accusation against foreign own-
ership is that it jeopardizes Canada’s political autonomy. However, such an accusa-
tion is difficult to prove or disprove.
There are various explanations of the high incidence of foreign ownership of the
Canadian economy. Some attribute it to the relatively high Canadian tariffs insti-
tuted with the implementation of the National Policy in 1879. Since foreign firms
couldn’t compete by exporting here because of the high tariffs, they established or
purchased production facilities in Canada. Our past patent laws, which allowed no
protection to a foreign patent owner, also helped to stimulate foreign ownership as
firms not wanting to have their technologies imitated quickly established them-
selves in Canada. Our country’s proximity to the United States has also no doubt
helped increase foreign ownership, as American firms viewed Canada as an exten-
sion of their domestic market.
All these explanations have some merit. However, all that can be said with cer-
tainty is that if foreign firms decided to establish productive capacities in Canada,
it must have been because it was the most profitable alternative.
 chapter four • an overview of the market system and the canadian economy
Suppose a municipality requires
a new road. In the absence of a
government request that a pri-
vate firm build it, it is unlikely
that a private firm will build the
required road on its own initia-
tive. Or, to express it in another
way, private markets will not
make available public goods.
The citizens of the municipality
have to elect a government to ei-
ther direct a private firm to build
the road, or hire people to buy
the capital equipment needed to
construct the road on its own.
Why would a private firm not
undertake to build a road on its
own? The obstacle is common
property rights. The land on
which the road is to be built must
be owned by the firm before it
would consider building the
road. Lands used by all citizens
are most often held publicly. The
firm would thus need to get the
consent of all the citizens af-
fected. Such unanimity would be
difficult to achieve. Indeed, it is
the difficulty of making collective
decisions that makes govern-
ments essential to the creation of
an infrastructure—such as roads
MARKET FAILURE AND THE NEED
FOR GOVERNMENT
Private markets fulfil individual desires very well, but
where there is a need for collective action, they often fail.
and airports—necessary to facili-
tate the functioning of markets.
Not only must a decision be
made to build the road, but then
the decision must be made as to
who should bear the cost. The
free-rider problem arises here.
Every individual hopes someone
will pay for the needed road. This
way he or she can have the ben-
efits without contributing to its
cost. The free-rider problem can
potentially arise in all situations
where collective action must be
taken. Unless we have a central
authority—government—with the
monopoly power to impose costs
on all members of a society,
many socially useful projects will
not be undertaken.
In a pathbreaking book, The
Logic of Collective Action,1 Man-
cur Olson pointed out some 30
years ago that contrary to popu-
lar belief, groups of individuals
with common interest do not
necessarily attempt to further
those common interests. In
many instances group members
attempt to further their own per-
sonal interests. A few years later,
the political scientist Garrett
95
Hardin popularized the term “the
tragedy of the commons”2 to de-
scribe the problems that arise
when there are common prop-
erty rights. For example, where
there are common property
rights to a natural resource, it is
typically overexploited. The cod
stocks on Canada’s east coast
have suffered just that fate.
Where collective action is re-
quired, or where there are com-
mon property rights, govern-
ments are needed because
markets fail to bring together the
interests of the individual and
those of society. The federal
government has had to impose
mandatory fishing restrictions to
save the cod stocks from dwin-
dling further. Governments must
make decisions to construct a
road, otherwise the road might
never get built. Clearly, markets
work best where there are pri-
vate property rights.
1
Mancur Olson, The Logic of Collec-
tive Action (Cambridge: Cambridge
University Press, 1965).
2 Garret Hardin, “The Tragedy of
the Commons,” Science 162 (1968):
1243–48.
96 Part One • An Introduction to Economics and the Economy
chapter summary
1. The market system—known also as the
private-enterprise system or capitalism—is
characterized by the private ownership of
resources, including capital, and the freedom
of individuals to engage in economic activi-
ties of their choice to advance their material
well-being. Self interest is the driving force of
such an economy, and competition functions
as a regulatory or control mechanism.
2. In the market system, markets and prices
organize and make effective the many mil-
lions of individual decisions that determine
what is produced, the methods of produc-
tion, and the sharing of output.
3. Specialization, use of advanced technology,
and the extensive use of capital goods are
facilitated by the market system.
4. Functioning as a medium of exchange, money
eliminates the problems of bartering and per-
mits easy trade and greater specialization,
both domestically and internationally.
5. Every economy faces Four Fundamental
Questions: (a) What goods and services will
be produced? (b) How will the goods and
services be produced? (c) Who will get the
goods and services? (d) How will the system
used accommodate changes in consumer
tastes, resource supplies, and technology?
6. The market system produces those products
of which production and sale yield total rev-
enue sufficient to cover all costs, including a
profit (a cost). It does not produce those
products that do not yield a profit.
7. Profit indicates that an industry is prosper-
ous and promotes its expansion. Losses sig-
nify that an industry is not prosperous and
hasten its contraction.
8. Consumer sovereignty means that both
businesses and resource suppliers are sub-
ject to the wants of consumers. Through
their dollar votes, consumers decide on the
composition of output.
9. Competition forces firms to use the lowest-
cost and therefore the most economically
efficient production techniques.
terms and concepts
barter, p. 80 consumer sovereignty, p. 83
competition, p. 78 creative destruction, p. 85
10. The prices that a household receives for the
resources it supplies to the economy deter-
mine that household’s income. This income
determines the households claim on the
economy’s output. Those who have income
to spend get the products produced in the
market system.
11. By communicating changes in consumer
tastes to resource suppliers and entrepre-
neurs, the market system prompts appropri-
ate adjustments in the allocation of the
economy’s resources. The market system
also encourages technological advance and
capital accumulation.
12. Competition, the primary mechanism of con-
trol in the market economy, promotes a unity
of self-interest and social interests; as though
directed by an “invisible hand,” competition
harnesses the self-interest motives of busi-
nesses and resource suppliers to further the
social interest.
13. Spillovers, or externalities, cause the equi-
librium output of certain goods to vary from
the socially efficient output. Spillover costs
result in an overallocation of resources, which
can be corrected by legislation or by specific
taxes. Spillover benefits are accompanied by
an underallocation of resources, which can
be corrected by government subsidies to
consumers or producers
14. Only government is willing to provide public
goods, which are indivisible and entail ben-
efits from which non-paying consumers (free
riders) cannot be excluded. Private firms
will not produce public goods. Quasi-public
goods have some of the characteristics of
public goods and some of the characteristics
of private goods; government provides them
because the private sector would underallo-
cate resources to their production.
15. In terms of both employment share and con-
tribution to domestic production, the service
sector dominates in the Canadian economy.
derived demand, p. 83
division of labour, p. 80
 chapter four • an overview of the market system and the canadian economy 97

dollar votes, p. 83 free-rider problem, p. 89 public good, p. 89

exclusion principle, p. 89
firm, p. 82
Four Fundamental Questions,
p. 82
freedom of choice, p. 77
freedom of enterprise, p. 77
guiding function of prices, p. 85
household, p. 82
“invisible hand,” p. 86
medium of exchange, p. 80
money, p. 81
private property, p. 76
quasi-public good, p. 89
roundabout production, p. 79
self-interest, p. 77
specialization, p. 79
spillover benefits, p. 88
spillover costs, p. 87

study questions
1. Explain each of the following statements:
a. The market system not only accepts self-
interest as a fact of human existence, it
relies on self-interest to achieve society’s
material goals.
b. The market system provides such a vari-
ety of desired goods and services pre-
cisely because no single individual or
small group is deciding what the econ-
omy will produce.
c. Entrepreneurs and business are at the
helm of the economy, but their com-
manders are consumers.
2. Why is private property, and the protection
of property rights, so critical to the success
of the market system?
3. What are the advantages of “roundabout”
production? What is meant by the term “divi-
sion of labour”? What are the advantages of
specialization in the use of human and mate-
rial resources? Explain: “Exchange is the nec-
essary consequence of specialization.”
4. What problem does barter entail? Indicate
the economic significance of money as a
medium of exchange. What is meant by
the statement “We want money only to part
with it”?
5. Evaluate and explain the following state-
ments:
a. The market system is a profit-and-loss
system.
b. Competition is the indispensable discipli-
narian of the market economy.
c. Production methods that are inferior in
the engineering sense may be the most
efficient methods in the economic sense,
once resource prices are considered.
6. Explain the meaning and implications of the
following quotation.
The beautiful consequence of the market
is that it is its own guardian. If output or
prices or certain kinds of remuneration
stray away from their socially ordained
levels, forces are set into motion to bring
them back to the fold. A curious paradox
thus ensues: the market, which is the
acme of individual economic freedom, is
the strictest taskmaster of all. One may
appeal the ruling of a planning board or
win the dispensation of a [government]
minister; but there is no appeal, no
dispensation, from the anonymous pres-
sures of the market mechanism. Eco-
nomic freedom is thus more illusory than
at first appears. One can do as one
pleases in the market. But if one pleases
to do what the market disapproves, the
price of individual freedom is economic
ruination.1
7. Suppose the demand for bagels rises dra-
matically while the demand for breakfast
cereal falls. Briefly explain how the compet-
itive market economy will make the needed
adjustments to re-establish an efficient allo-
cation of society’s scarce resources?
8. KEY QUESTION Some large hard-
ware stores, such as Canadian Tire, boasts of
carrying as many as 20,000 different prod-
ucts in each store. What motivated the pro-
ducers of those products—everything from
screwdrivers to ladders to water heaters—to
make them and offer them for sale? How did
the producers decide on the best combina-
tions of resources to use? Who made those
resources available, and why? Who decides
whether these particular hardware products

1
Robert L. Heilbroner, The Worldly Philosophers, 7th ed. (New York: Simon & Schuster, 1999), pp. 57–58.
98 Part One • An Introduction to Economics and the Economy
should continue to get produced and offered
for sale?
9. In a single sentence, describe the meaning of
the phrase “invisible hand.”
10. What divergences arise between equilibrium
output and efficient output when (a) spill-
over costs and (b) spillover benefits are pres-
ent? How might government correct for
these divergences? “The presence of spill-
over costs suggests the underallocation of
resources to a particular product and the
need for governmental subsidies.” Do you
agree? Why or why not? Explain how zoning
and seat belt laws might be used to deal with
a problem of spillover costs.
11. KEY QUESTION What are the charac-
teristics of public goods? Explain the signifi-
cance of the exclusion principle. By what
means does government provide public
goods?
internet application questions
1. Sparkly Things—Interested in Buying One?
Go to the Internet auction site eBay at
www.ebay.com/index.html and click the cat-
egory Jewelry, Gemstones. How many dia-
monds are for sale at the moment? How
many rubies, sapphires, and opals? Note the
wide array of sizes and prices of the gem-
stones. In what sense is there competition
among the sellers in these markets? How
does that competition influence prices? In
what sense is there competition among buy-
ers? How does that competition influence
prices? See something interesting, there or
elsewhere on eBay? Go ahead and buy it!
12. KEY QUESTION Draw a production
possibilities curve with public goods on the
vertical axis and private goods on the hori-
zontal axis. Assuming the economy is ini-
tially operating on the curve, indicate how
the production of public goods might be
increased. How might the output of public
goods be increased if the economy is initially
operating at a point inside the curve?
13. Use your understanding of the characteris-
tics of private and public goods to determine
whether the following should be produced
through the market system or provided by
government: (a) bread; (b) street lighting;
(c) bridges; (d) parks; (e) swimming pools;
(f) medical care; (g) mail delivery; (h) hous-
ing; (i) air traffic control; (j) libraries. State
why you answered as you did in each case.
14. (The Last Word) Why do private markets
fail? In your answer, refer to the dwindling
cod stocks on Canada’s east coast.
2. Barter and Canada Revenue Bartering occurs
when goods or services are exchanged with-
out the exchange of money. For some,
barter’s popularity is that it enables them to
avoid paying taxes to the government. How
might such avoidance occur? Canada Rev-
enue’s interpretation of barter transactions
can be found at www.ccra-adrc.gc.ca/E/pub/
tp/it490et/it490e.txt.html. Does Canada Rev-
enue treat barter as taxable or nontaxable
income? How is the value of a barter transac-
tion determined?
 FIVE

Canada in
the Global
Economy

B
ackpackers in the wilderness like to

IN THIS CHAPTER think they are “leaving the world

Y OU WILL LEARN:
behind,” but, like Atlas, they carry the
That trade is crucial to
Canada’s economic well-being. world on their shoulders. Much of their equip-
•
ment is imported—knives from Switzerland,
The importance of specialization
and comparative advantage in rain gear from South Korea, cameras from
international trade.
• Japan, aluminum pots from England, minia-
How the value of a currency
is established on foreign ture stoves from Sweden, sleeping bags from
exchange markets.
• China, and compasses from Finland. More-
The economic costs of
trade barriers. over, they may have driven to the trailheads in
•
Japanese-made Toyotas or Swedish-made
About multilateral trade
agreements and free trade zones.
Volvos, sipping coffee from Brazil or snacking

on bananas from Honduras.

100 Part One • An Introduction to Economics and the Economy

International trade and the global economy affect all of us daily, whether we are hik-
ing in the wilderness, driving our cars, listening to music, or working at our jobs.
We cannot “leave the world behind.” We are enmeshed in a global web of economic
relationships—trading of goods and services, multinational corporations, coopera-
tive ventures among the world’s firms, and ties among the world’s financial mar-
kets. That web is so complex that it is difficult to determine just what is—or isn’t—a
Canadian product. A Finnish company owns Wilson sporting goods; a Swiss com-
pany owns Gerber baby food; and a British corporation owns Burger King. The Toy-
ota Corolla sedan is manufactured in Canada. Many “Canadian” products are made
with components from abroad, and, conversely, many “foreign” products contain
numerous Canadian-produced parts.

International Linkages
Several economic flows link the Canadian economy and the economies of other
nations. As identified in Figure 5-1, these flows are:
● Goods and services flows or simply trade flows Canada exports goods and
www.oecd.org/
eco/out/eo.htm services to other nations and imports goods and services from them.
OECD Economic
● Capital and labour flows or simply resource flows Canadian firms establish
Outlook
production facilities—new capital—in foreign countries and foreign firms
establish production facilities in Canada. Labour also moves between nations.
Each year many foreigners immigrate to Canada and some Canadians move
to other nations.
● Information and technology flows Canada transmits information to other
nations about Canadian products, price, interest rates, and investment oppor-
tunities and receives such information from abroad. Firms in other countries
use technology created in Canada and Canadian businesses incorporate tech-
nology developed abroad.

FIGURE 5-1 INTERNATIONAL LINKAGES

The Canadian econ-
omy is intertwined
with other national Goods and services
economies through
goods and service
flows (trade flows),
capital and labour Capital and labour
flows (resource Other
Canadian national
flows), information economy economies
and technology flows,
and financial flows. Information and
technology

Money
 chapter five • canada in the global economy 101

● Financial flows Money is transferred between Canada and other countries

for several purposes, for example, paying for imports, buying foreign assets,
paying interest on debt, and providing foreign aid.

Canada and World Trade

Our main goal in this chapter is to examine trade flows and the financial flows that
pay for them. What is the extent and pattern of international trade and how much
has it grown? Who are the major participants?

Volume and Pattern

Global Perspective 5.1 suggests the importance of world trade for selected countries.
Canada, with a limited domestic market, cannot efficiently produce the variety of
goods its citizens want. So we must import goods from other nations. That, in turn,
means that we must export, or sell abroad, some of our own products. For Canada,
exports make up about 40 percent of our gross domestic output (GDP)—the market
value of all goods and services produced in an economy. Other countries, the
United States, for example, have a large internal market. Although the total volume
of trade is huge in the United States, it constitutes a much smaller percentage of
GDP than in a number of other nations.

5.1

Exports of goods The Netherlands

and services as a
percentage of Canada
GDP, selected
countries, 1999 New Zealand
Canada’s exports
United Kingdom
make up almost 40
percent of domestic France
output of goods and
services. Germany

Italy

U.S.A.

Japan

0 10 20 30 40 50 60
Source: IMF, International Financial Statistics, 2000
102 Part One • An Introduction to Economics and the Economy

VOLUME
For Canada and for the world as a whole the volume of international trade has been
increasing both absolutely and relative to their GDPs. A comparison of the boxed
data in Figure 5-2 reveals substantial growth in the dollar amount of Canadian
exports and imports over the past several decades. The graph shows the growth of
Canadian exports and imports of goods and services as percentages of GDP. Cana-
dian exports and imports currently are approximately 40 percent of GDP, about
double their percentages in 1965.

DEPENDENCE
Canada is almost entirely dependent on other countries for bananas, cocoa, cof-
fee, spices, tea, raw silk, nickel, tin, natural rubber, and diamonds. Imported
goods compete with Canadian goods in many of our domestic markets: Japanese
cars, French and American wines, and Swiss and Austrian snow skis are a few
examples.
Of course, world trade is a two-way street. Many Canadian industries rely on for-
eign markets. Almost all segments of Canadian agriculture rely on sales abroad; for
example, exports of wheat, corn, and tobacco vary from one-fourth to more than
one-half of the total output of those crops. The Canadian computer, chemical, air-
craft, automobile, and machine tool industries, among many others, sell significant
portions of their output in international markets. Table 5-1 shows some of the major
Canadian exports and imports.

FIGURE 5-2 CANADIAN TRADE AS PERCENTAGE OF GDP

Canadian imports
and exports of goods 1971 2000
and services have Exports = $21.1 billion Exports = $475.8 billion
Imports = $19.5 billion Imports = $427.4 billion
increased in volume
and have doubled as
a percentage of GDP 50
since 1971. (Source:
Statistics Canada, 45
CANSIM, series
D15458 and D15471.)
40
Visit www.mcgrawhill.
Percentage of GDP

ca/college/mcconnell9
for data update. 35

30 Exports

25
Imports
20

15

0
1971 1975 1980 1985 1990 1995 2000
 chapter five • canada in the global economy 103

TABLE 5-1 PRINCIPAL CANADIAN EXPORTS AND IMPORTS

OF GOODS, 2000
Exports % of Total Imports % of Total

Machinery and equipment 25 Machinery and equipment 34

Automotive products 23 Automotive products 21
Industrial goods and materials 15 Industrial goods and materials 19
Forestry products 10 Consumer goods 11
Energy products 13 Agricultural and fishing products 5
Agricultural and fishing products 7 Energy products 5
Source: Statistics Canada, www.statisticscanada.ca/english/Pgdb/Economy/International/gblec05.htm
Visit www.mcgrawhill.ca/college/mcconnell9 for data update.

TRADE PATTERNS
The following facts will give you an overview of international trade:
● Canada has a trade surplus in goods. In 2000, Canadian exports of goods
exceeded Canadian imports of goods by $54.5 billion.
● Canada has a trade deficit in services (such as accounting services and financial
services). In 2000, Canadian imports of services exceeded export of services by
$6.6 billion.
● Canada imports some of the same categories of goods that it exports, specifi-
cally, automobiles products and machinery and equipment (see Table 5-2).
● As Table 5-2 implies, Canada’s export and import trade is with other industri-
ally advanced nations, not with developing countries. (Although data in this
table are for goods only, the same general pattern applies to services).
● The United States is Canada’s most important trading partner quantitatively.
In 2000, 86 percent of Canadian exported goods were sold to Americans, who
in turn provided 74 percent of Canada’s imports of goods (see Table 5-2).

TABLE 5-2 CANADIAN FINANCIAL LINKAGES

EXPORTS AND International trade requires complex financial
IMPORTS OF linkages among nations. How does a nation
GOODS BY AREA, obtain more goods from others than it provides
2000 to them? The answer is by either borrowing
from foreigners or by selling real assets (for
Percentage Percentage
Exports to of total Imports from of total example, factories, real estate) to them.

United States 86 United States 74

Rapid Trade Growth
European Union 5 European Union 9
Several factors have propelled the rapid growth
Japan 3 Japan 3
of international trade since World War II.
Other countries 6 Other countries 14
Source: Statistics Canada, www.statisticscanada.ca/ TRANSPORTATION TECHNOLOGY
english/Pgdb/Economy/International/gblec02a.htm
Visit www.mcgrawhill.ca/college/mcconnell9 for data update. High transportation costs are a barrier to any
type of trade, particularly among traders who
104 Part One • An Introduction to Economics and the Economy

are distant from one another. But improvements in transportation have shrunk the
globe and have fostered world trade. Airplanes now transport low-weight, high-
value items such as diamonds and semiconductors swiftly from one nation to
another. We now routinely transport oil in massive tankers, significantly lowering
the cost of transportation per barrel. Grain is loaded onto ocean-going ships at mod-
ern, efficient grain silos at Great Lakes and coastal ports. Natural gas flows through
large-diameter pipelines from exporting to importing countries—for instance, from
Russia to Germany and from Canada to the United States.

COMMUNICATIONS TECHNOLOGY
Dramatic improvements in communications technology have also advanced world
trade. Computers, the Internet, telephones, and fax (facsimile) machines now
directly link traders around the world, enabling exporters to assess overseas mar-
kets and to carry out trade deals. A distributor in Vancouver can get a price quote
on 1000 woven baskets in Thailand as quickly as a quote on 1000 laptop computers
in Ontario. Money moves around the world in the blink of an eye. Exchange rates,
stock prices, and interest rates flash onto computer screens nearly simultaneously
in Toronto, London, and Lisbon.

GENERAL DECLINE IN TARIFFS

Tariffs are excise taxes (duties) on imported products. They have had their ups and
downs over the years, but since 1940 they have generally fallen. A glance ahead to
Figure 5-5 shows that Canadian tariffs as a percentage of imports are now about 5
percent, down from over 40 percent in 1940. Many nations still maintain barriers to
free trade, but, on average, tariffs have fallen significantly, thus increasing interna-
tional trade.

Participants in International Trade

All the nations of the world participate to some extent in international trade.

NORTH AMERICA, JAPAN, AND WESTERN EUROPE

As Global Perspective 5.2 indicates, the top participants in world trade by total vol-
ume are the United States, Germany, and Japan. In 1999 those three nations had com-
bined exports of $1.6 trillion. Along with Germany, other Western European nations
such as France, Britain, and Italy are major exporters and importers. Canada is the
world’s sixth largest exporter. Canada, the United States, Japan, and the Western
European nations also form the heart of the world’s financial systems and provide
multi- headquarters for most of the world’s largest multinational corporations—firms that
national have sizable production and distribution activities in other countries. Examples of
corporation such firms are Unilever (Netherlands), Nestlé (Switzerland), Coca-Cola (United
A firm that owns
production facilities
States), Bayer Chemicals (Germany), Mitsubishi (Japan), and Nortel (Canada).
in other countries
and produces and NEW PARTICIPANTS
sells its product
Important new participants have arrived on the world trade scene. One group is
abroad.
made up of the newly industrializing Asian economies of Hong Kong (now part of
China), Singapore, South Korea, and Taiwan. Although these Asian economies
experienced economic difficulties in the 1990s, they have expanded their share of
world exports from about 3 percent in 1972 to more than 10 percent today. Together,
 chapter five • canada in the global economy 105

5.2

Exports of goods, 1999

Comparative exports (billions of dollars)
0 100 200 300 400 500 600
The United States, Germany,
United States
and Japan are the world’s
Germany
largest exporters. Canada
Japan
ranks sixth.
France
Britain
Canada
Italy
Netherlands
China
Belgium-Lux.
South Korea
Mexico
Taiwan
Singapore
Spain
Source: World Trade Organization, www.wto.org

they export about as much as either Germany or Japan and much more than France,
Britain, or Italy. Other economies in southeast Asia, particularly Malaysia and
Indonesia, also have expanded their international trade.
China, with its increasing reliance on the market system, is an emerging major
trader. Since initiating market reforms in 1978, its annual growth of output has aver-
aged 9 percent (compared with 2 to 3 percent annually over that period in Canada).
At this remarkable rate, China’s total output nearly doubles every eight years! An
upsurge of exports and imports has accompanied that expansion of output. In 1989,
Chinese exports and imports were each about $50 billion. In 1999, each topped $200
billion, with 33 percent of China’s exports going to Canada and the United States.
Also, China has been attracting substantial foreign investment (more than $800 bil-
lion since 1990).
The collapse of communism in Eastern Europe and the former Soviet Union in
the early 1990s altered world trade patterns. Before that collapse, the Eastern Euro-
pean nations of Poland, Hungary, Czechoslovakia, and East Germany traded mainly
with the Soviet Union and such political allies as North Korea and Cuba. Today, East
Germany is reunited with West Germany, and Poland, Hungary, and the Czech
Republic have established new trade relationships with Western Europe, Canada,
and the United States.
Russia itself has initiated far-reaching market reforms, including widespread pri-
vatization of industry, and has major trade deals with firms around the globe.
Although its transition to capitalism has been far from smooth, Russia may one day
106 Part One • An Introduction to Economics and the Economy

be a major trading nation. Other former Soviet republics—now independent

nations—such as Estonia and Azerbaijan also have opened their economies to inter-
national trade and finance.

Back to the Circular Flow Model

We can easily add “the rest of the world” to Chapter 4’s circular flow model. We do
so in Figure 5-3 via two adjustments.
1. Our previous “Resource Markets” and “Product Markets” now become “Cana-
dian Resource Markets” and “Canadian Product Markets.” Similarly, we add
the modifier “Canadian” to the “Businesses,” “Government,” and “Households”
sectors.

FIGURE 5-3 THE CIRCULAR FLOW WITH THE FOREIGN SECTOR

Flows 13–16 in the
lower portion of the (1) Costs Money income (rents, w
CANADIAN age
diagram show how s,
RESOURCE in
the Canadian econ- MARKETS Land, labour, capita
l,
t

er
omy interacts with

es
(2) Resources entrepreneurial ab

t, p
“The Rest of the i lit
y

rofits)
World.” People
abroad buy Canadian
(7) (8)
exports, contributing Expenditures Resources
to our business rev-
enue and money
(10) (9)
income. Canadians, Goods and services Goods and services
in turn, spend part of
their incomes to buy CANADIAN CANADIAN CANADIAN
BUSINESSES GOVERNMENT HOUSEHOLDS
imports from abroad.
Income from a Net taxes Net taxes
nation’s exports helps (11) (12)
pay for its imports.
(5) (6)
Expenditures Goods and
services

Go (4)
o ds and services Goods and ser v ic e s
CANADIAN
PRODUCT
MARKETS re s
d it u
(3) Revenue Consumption e xpen

(13) (16)
Canadian exports Canadian imports

(14) (15)
Foreign Canadian
expenditures expenditures
REST
OF THE
WORLD
 chapter five • canada in the global economy 107

2. We place the foreign sector—the “Rest of the World”—so that it interacts

with Canadian Product Markets. This sector designates all foreign nations
that we deal with and the individuals, businesses, and governments that make
them up.
Flow (13) in Figure 5-3 shows that people, businesses, and governments abroad buy
Canadian products—our exports—from our product market. This goods and services
flow of Canadian exports to foreign nations is accompanied by an opposite mone-
tary revenue flow (14) from the rest of the world to us. In response to these revenues
from abroad, Canadian businesses demand more domestic resources (flow 2) to pro-
duce the goods for export; they pay for these resources with revenues from abroad.
Thus, the domestic flow (1) of money income (rents, wages, interest, and profits) to
Canadian households rises.
But our exports are only half the picture. Flow (15) shows that Canadian
households, businesses, and government spend some of their income on for-
eign products. These products, of course, are our imports (flow 16). Purchases of
imports, say, autos and electronic equipment, contribute to foreign output and
income, which in turn provides the means for foreign households to buy Canadian
exports.
Our circular flow model is a simplification that emphasizes product market
effects, but a few other Canada–Rest of the World relationships also require com-
ment. Specifically, there are linkages between the Canadian resource markets and
the rest of the world.
Canada imports and exports not only products, but also resources. For example,
we import some crude oil and export raw logs. Moreover, some Canadian firms
choose to engage in production abroad, which diverts spending on capital from our
domestic resource market to resource markets in other nations. For instance, Nortel
has an assembly plant in Switzerland. Or flowing the other direction, Sony might
construct a plant for manufacturing CD players in Canada.
There are also international flows of labour. About 200,000 immigrants enter
Canada each year. These immigrants expand the availability of labour resources in
Canada, raising our total output and income. On the other hand, immigration tends
to increase the labour supply in certain Canadian labour markets, reducing wage
rates for some types of Canadian labour.
The expanded circular flow model also demonstrates that a nation engaged in
world trade faces potential sources of instability that would not affect a “closed”
nation. Recessions and inflation can be highly contagious among nations. Suppose
the United States experienced a severe recession. As its income declines, its pur-
chases of Canadian exports fall. As a result, flows (13) and (14) in Figure 5-3 decline
and inventories of unsold Canadian goods rise. Canadian firms would respond by
limiting their production and employment, reducing the flow of money income to
Canadian households (flow 1). Recession in the United States in this case con-
tributed to a recession in Canada.
Figure 5-3 also helps us to see that the foreign sector alters resource allocation and
incomes in the Canadian economy. With a foreign sector, we produce more of some
goods (our exports) and fewer of others (our imports) than we would otherwise.
Thus, Canadian labour and other resources are shifted towards export industries
and away from import industries. We use more of our resources to manufacture
autos and telecommunication equipment. So we ask: “Do these shifts of resources
make economic sense? Do they enhance our total output and thus our standard of
living?” We look at some answers next. (Key Question 4)
108 Part One • An Introduction to Economics and the Economy

● There are four main categories of economic
flows linking nations: goods and services flows,
capital and labour flows, information and tech-
nology flows, and financial flows.
● World trade has increased globally and nation-
ally. In terms of volume, Canada is the world’s
seventh largest international trader. With ex-
ports and imports of about 40 percent of GDP,
Canada is more dependent on international
trade than most other nations.
● Advances in transportation and communica-
tions technology and declines in tariffs have all
helped expand world trade.
● North America, Japan, and the Western Euro-
pean nations dominate world trade. Recent new
traders are the Asian economies of Singapore,
South Korea, Taiwan, and China (including Hong
Kong), the Eastern European nations, and the
former Soviet states.
● The circular flow model with foreign trade
includes flows of exports from our domestic
product market, imports to our domestic prod-
uct market, and the corresponding flows of
spending.

Specialization and Comparative Advantage

Specialization and international trade increase the productivity of a nation’s resources and
Specialization
and Trade allow for greater total output than would otherwise be possible. This idea is not new.
Adam Smith pointed it out over 200 years ago. Nations specialize and trade for the
same reasons as individuals do: Specialization and exchange result in greater over-
all output and income.

Basic Principle
In the early 1800s British economist David Ricardo expanded Smith’s idea, observ-
ing that it pays for a person or a country to specialize and exchange even if that per-
son or nation is more productive than a potential trading partner in all economic
activities.
Consider an example of a chartered accountant (CA) who is also a skilled house
painter. Suppose the CA can paint her house in less time than the professional
painter she is thinking of hiring. Also suppose the CA can earn $50 per hour doing
her accounting and must pay the painter $15 per hour. Let’s say that it will take the
accountant 30 hours to paint her house; the painter, 40 hours.
Should the CA take time from her accounting to paint her own house or should
she hire the painter? The CA’s opportunity cost of painting her house is $1500 (= 30
hours × $50 per hour of sacrificed income). The cost of hiring the painter is only $600
(40 hours × $15 per hour paid to the painter). The CA is better at both accounting
absolute and painting—she has an absolute advantage in both accounting and painting. But
advantage her relative advantage (about which more below) is in accounting. She will get her
When a region or house painted at a lower cost by specializing in accounting and using some of the earnings
nation can produce
more of good X and
from accounting to hire a house painter.
good Y with less Similarly, the house painter can reduce his cost of obtaining accounting services
resources compared by specializing in painting and using some of his income to hire the CA to prepare
to other regions or his income tax forms. Suppose that it would take the painter ten hours to prepare
nations. his tax return, while the CA could handle this task in two hours. The house painter
would sacrifice $150 of income (= 10 hours × $15 per hour of sacrificed time) to
accomplish a task that he could hire the CA to do for $100 (= 2 hours × $50 per hour
 chapter five • canada in the global economy 109

of the CA’s time). By using the CA to prepare

TABLE 5-3 MEXICO’S his tax return, the painter lowers his cost of get-
PRODUCTION ting the tax return prepared.
POSSIBILITIES What is true for our CA and house painter
TABLE (IN TONNES) is also true for nations. Specializing enables
nations to reduce the cost of obtaining the
PRODUCTION ALTERNATIVES goods and services they desire.
Product A B C D E

Corn 0 20 24 40 60
Comparative Costs
Soybeans 15 10 9 5 0
Our simple example shows that specialization
is economically desirable because it results in
more efficient production. Let’s now put spe-
TABLE 5-4 CANADA’S cialization in the context of trading nations,
PRODUCTION using the familiar concept of the production
POSSIBILITIES possibilities table for our analysis. Suppose pro-
TABLE (IN TONNES) duction possibilities for two products in Mexico
and Canada are as shown in Tables 5-3 and 5-4.
PRODUCTION ALTERNATIVES In these tables we assume constant costs. Each
Product R S T U V country must give up a constant amount of one
product to secure a particular increment of the
Corn 0 30 33 60 90
other product. (This assumption simplifies our
Soybeans 30 20 19 10 0 discussion without impairing the validity of
our conclusions.)
Specialization and trade are mutually beneficial
or “profitable” to the two nations if the comparative costs of the two products within
the two nations differ. What are the comparative costs of corn and soybeans in Mex-
ico? By comparing production alternatives A and B in Table 5-4, we see that five tonnes
of soybeans (= 15 – 10) must be sacrificed to produce 20 tonnes of corn (= 20 – 0). Or
more simply, in Mexico it costs one tonne of soybeans (S) to produce four tonnes of
corn (C); that is, 1S ≡ 4C. Because we assumed constant costs, this domestic compara-
tive-cost ratio will not change as Mexico expands the output of either product. This is
evident from looking at production possibilities B and C, where we see that four more
tonnes of corn (= 24 – 20) cost one unit of soybeans (= 10 – 9).
Similarly, in Table 5-5, comparing Canadian production alternatives R and S
reveals that in Canada it costs 10 tonnes of soybeans (= 30 – 20) to obtain 30 tonnes
of corn (= 30 – 0). That is, the domestic comparative-cost ratio for the two products
in Canada is 1S ≡ 3C. Comparing production alternative S and T reinforces this; an
extra three tonnes of corn (= 33 – 30) comes at the direct sacrifice of one tonne of soy-
beans (= 20 – 19).
The comparative costs, or internal terms of trade, of the two products within the
two nations are clearly different. Economists say that Canada has a domestic com-
comparative parative advantage or, simply, a comparative advantage over Mexico in soybeans.
advantage Canada must forgo only three tonnes of corn to get one tonne of soybeans, but Mex-
When a region or ico must forgo four tonnes of corn to get one tonne of soybeans. In terms of domes-
nation can produce
a good at a lower
tic opportunity costs, soybeans are relatively cheaper in Canada. A nation has a
domestic opportu- comparative advantage in some product when it can produce that product at a lower domes-
nity cost compared tic opportunity cost than can a potential trading partner. Mexico, in contrast, has a com-
to a potential trad- parative advantage in corn. While one tonne of corn costs one-third tonne of soybeans
ing partner. in Canada, it costs only one-quarter tonne of soybeans in Mexico. Comparatively
speaking, corn is cheaper in Mexico. We summarize the situation in Table 5-5.
110 Part One • An Introduction to Economics and the Economy

Because of these differences in domestic

TABLE 5-5 COMPARATIVE comparative costs, if both nations specialize,
ADVANTAGE each according to its comparative advantage,
EXAMPLE: A each can achieve a larger total output with the
SUMMARY same total input of resources. Together they will
be using their scarce resources more efficiently.
Soybeans Corn

Mexico: Must give up Mexico: Must give up Terms of Trade

4 tonnes of corn to get ⁄4 tonne of soybeans to
1

1 tonne of soybeans get 1 tonne of corn Canada can shift production between soybeans
and corn at the rate of 1S for 3C. Thus, Canadi-
Canada: Must give up Canada: Must give up
3 tonnes of corn to get 1
⁄3 tonne of soybeans to
ans would specialize in soybeans only if they
1 tonne of soybeans get 1 tonne of corn could obtain more than three tonnes of corn for
one tonne of soybeans by trading with Mexico.
Comparative advantage: Comparative advantage:
Canada Mexico
Similarly, Mexico can shift production at the
rate of 4C for 1S. So it would be advantageous
to Mexico to specialize in corn if it could get one
tonne of soybeans for less than four tonnes of corn.
Suppose that through negotiation the two nations agree on an exchange rate of
terms of one tonne of soybeans for three-and-a-half tonnes of corn. These terms of trade are
trade The mutually beneficial to both countries since each can “do better” through such trade
amount of one than via domestic production alone. Canadians can get three-and-a-half tonnes of
good or service
that must be given
corn by sending one tonne of soybeans to Mexico, while they can get only three
up to obtain one tonnes of corn by shifting resources domestically from soybeans to corn. Mexicans
unit of another can obtain one tonne of soybeans at a lower cost of three-and-a-half tonnes of corn
good or service. through trade with Canada, compared to the cost of four tonnes if Mexicans pro-
duce one tonne of corn themselves.

Gains from Specialization and Trade

Let’s pinpoint the size of the gains in total output from specialization and trade.
Suppose that before specialization and trade, production alternative C in Table 5-3
and alternative T in Table 5-4 were the optimal product mixes for the two countries.
These outputs are shown in column 1 of Table 5-6. That is, Mexicans preferred 24
tonnes of corn and 9 tonnes of soybeans (Table 5-3) and Canadians preferred 33
tonnes of corn and 19 tonnes of soybeans (Table 5-4) to all other alternatives.

TABLE 5-6 SPECIALIZATION ACCORDING TO COMPARATIVE

ADVANTAGE AND THE GAINS FROM TRADE
(IN TONNES)
(1) (2) (3) (4) (5)
Outputs before Outputs after Amounts Outputs available Gains from specialization
Country specialization specialization traded after trade and trade (4) – (1)

Mexico 24 corn 60 corn –35 corn 25 corn 1 corn

9 soybeans 0 soybeans +10 soybeans 10 soybeans 1 soybeans
Canada 33 corn 0 corn +35 corn 35 corn 2 corn
19 soybeans 30 soybeans –10 soybeans 20 soybeans 1 soybeans
 chapter five • canada in the global economy 111

Now assume both nations specialize according to comparative advantage, Mex-

ico producing 60 tonnes of corn and no soybeans (alternative E) and Canada pro-
ducing no corn and 30 tonnes of soybeans (alternative R). These outputs are
reflected in column 2 of Table 5-6. Using our 1S = 31⁄2C terms of trade, assume Mex-
ico exchanges 35 tonnes of corn for 10 tonnes of Canadian soybeans. Column 3 of
Table 5-6 shows the quantities exchanged in this trade. As indicated in Column 4,
after trade Mexicans have 25 tonnes of corn and 10 tonnes of soybeans, while Cana-
dians have 35 tonnes of corn and 20 tonnes of soybeans. Compared with their opti-
mum product mixes before specialization and trade (column 1), both nations now
enjoy more corn and more soybeans! Specifically, Mexico has gained one tonne of
corn and one tonne of soybeans. Canada has gained two tonnes of corn and one
tonne of soybeans. These gains are shown in column 5.
Specialization based on comparative advantage improves resource allocation. The same
total inputs of world resources result in a larger global output. If Mexico and Canada allo-
cate all their resources to corn and soybeans respectively, the same total inputs of
resources can produce more output between them, indicating that resources are
being used or allocated more efficiently.
We noted in Chapter 2 that through specialization and international trade a nation
can overcome the production constraints imposed by its domestic production possi-
bilities table and curve. Table 5-6 and its discussion show just how this is done. The
domestic production possibilities data of the two countries have not changed, mean-
ing that neither nation’s production possibilities curve has shifted. But specialization
and trade mean that citizens of both countries have enjoyed increased consumption.
Thus, specialization and trade have the same effect as an increase in resources or tech-
nological progress: they make more goods available to an economy. (Key Question 5)

Foreign Exchange Market

Buyers and sellers, whether individuals, firms, or nations, use money to buy prod-
ucts or to pay for the use of resources. Within the economy, prices are stated in the
domestic currency and buyers use that currency to purchase domestic products. In
Mexico, for example, buyers possess pesos, exactly the currency that sellers want.
International markets are different. How many dollars does it take to buy a truck-
load of Mexican corn selling for 3000 pesos, a German automobile selling for 90,000
euros, or a Japanese motorcycle priced at 300,000 yen? Producers in Mexico, Germany,
and Japan want payment in pesos, euros, and yen, respectively, so they can pay their
foreign wages, rent, interest, dividends, and taxes. A foreign exchange market, a market in
exchange which various national currencies are exchanged for one another, serves this need. The equi-
market A librium prices in these markets are called exchange rates—the rate at which the currency
market in which the
money (currency) of one nation is exchanged for the currency of another nation. (See Global Perspective 5.3.)
of one nation can Two points about the foreign exchange market are particularly noteworthy:
be used to purchase
(can be exchanged 1. A Competitive Market Real-world foreign exchange markets conform closely
for) the money of to the markets discussed in Chapter 3. They are competitive markets character-
another nation. ized by large numbers of buyers and sellers dealing in standardized products
such as the Canadian dollar, the European euro, the British pound, the Swedish
exchange krona, and the Japanese yen.
rate The rate at
which the currency 2. Linkages to all Domestic and Foreign Prices The market price or exchange rate
of one nation is
exchanged for the
of a nation’s currency is an unusual price; it links all domestic (say, Canadian)
currency of another prices with all foreign (say, Japanese or German) prices. Exchange rates enable
nation. consumers in one country to translate prices of foreign goods into units of their
112 Part One • An Introduction to Economics and the Economy

5.3

$1 Will Buy
Exchange rates: foreign
currency per Canadian dollar 1.39 German marks
.44 British pounds
The amount of foreign currency
.57 U.S. dollars
which a dollar will buy varies
5.97 Mexican pesos
greatly from nation to nation. These
amounts are for April 2001 and 1.08 Swiss francs
fluctuate in response to supply 4.67 French francs
and demand changes in the foreign 80 Japanese yen
exchange market. 855 South Korean won
1380 Italian lira

own currency: They need only multiply the foreign product price by the
exchange rate. If the dollar-yen exchange rate is $.01 (1 cent) per yen, a Sony tel-
evision set priced at ¥20,000 will cost a Canadian $200 (= 20,000 × $.01). If the
exchange rate is $.02 (2 cents) per yen, it will cost a Canadian $400 (= 20,000 ×
$.02). Similarly, all other Japanese products would double in price to Canadian
buyers. As you will see, a change in exchange rates has important implications
for a nation’s level of domestic production and employment.

Dollar-Yen Market
How does the foreign exchange market work? Let’s look briefly at the market for dol-
lars and yen, leaving details to a later chapter. Canadian firms exporting to Japan
want payment in dollars, not yen; but Japanese importers of Canadian goods possess
yen, not dollars. So the Japanese importers are willing to supply their yen in
exchange for dollars in the foreign exchange market. At the same time, there are
Canadian importers of Japanese goods who need to pay Japanese exporters with yen,
not dollars. These Canadians go to the foreign exchange market as demanders of yen.
We then have a market in which the “price” is in dollars and the “product” is yen.
Figure 5-4 shows the supply of yen (by Japanese importers) and the demand for
yen (by Canadian importers). The intersection of demand curve Dy and supply
curve Sy establishes the equilibrium dollar price of yen. Here the equilibrium price
of 1 yen—the dollar-yen exchange rate—is 1 cent per yen, or $.01 = ¥1. At this price,
the market for yen clears; there is neither a shortage nor a surplus of yen. The equi-
librium $.01 price of 1 yen means that $1 will buy 100 yen or ¥100 worth of Japan-
ese goods. Conversely, 100 yen will buy $1 worth of Canadian goods.

Changing Rates: Depreciation and Appreciation

What might cause the exchange rate to change? The determinants of the demand for
and supply of yen are similar to the determinants of demand and supply for almost
any product. In Canada, several things might increase the demand for—and there-
fore the dollar price of—yen. Incomes might rise in Canada, enabling Canadians to
buy not only more domestic goods but also more Sony televisions, Nikon cameras,
 chapter five • canada in the global economy 113

FIGURE 5-4 THE MARKET FOR YEN

Canadian imports P
from Japan create a
demand Dy for yen, Sy
while Canadian
exports to Japan Exchange

Dollar price of 1 yen

rate : $.01 = ¥1
create a supply Sy of
yen. The dollar price
of one yen—the
exchange rate—is .01
determined at the
intersection of the
supply and demand
curves. In this case
the equilibrium price
Dy
is $.01, meaning that
1 cent will buy 1 yen.
0 Qe Q
Quantity of yen

and Nissan automobiles from Japan. So Canadians would need more yen and the
demand for yen would increase. Or a change in Canadian tastes might enhance their
preferences for Japanese goods. When gas prices soared in the 1970s, many Cana-
dian auto buyers shifted their demands from gas-guzzling domestic cars to gas-
efficient Japanese compact cars. The result was an increased demand for yen.
The point is that an increase in the Canadian demand for Japanese goods will
increase the demand for yen and raise the dollar price of yen. Suppose the dollar
price of yen rises from $.01 = ¥1 to $.02 = ¥1. When the dollar price of yen increases,
depreciation we say a depreciation of the dollar relative to the yen has occurred: It then takes
(of the dol- more dollars (pennies in this case) to buy a single unit of the foreign currency (a
lar) A decrease yen). Alternatively stated, the international value of the dollar has declined. A depre-
in the value of the
dollar relative to
ciated dollar buys fewer yen and therefore fewer Japanese goods; the yen and all
another currency so Japanese goods have become more expensive to Canadians. Result: Canadian con-
that a dollar buys a sumers shift their expenditures from Japanese goods to now less expensive Cana-
smaller amount of dian goods. The Ford Taurus becomes relatively more attractive than the Honda
the foreign currency. Accord to Canadian consumers. Conversely, because each yen buys more dollars—
that is, because the international value of the yen has increased—Canadian goods
become cheaper to people in Japan and Canadian exports to Japan rise.
If the opposite event occurred—if the Japanese demanded more Canadian
appreciation goods—then they would supply more yen to pay for these goods. The increase in the
(of the dol-
lar) An increase supply of yen relative to the demand for yen would decrease the equilibrium price
in the value of the of yen in the foreign exchange market. For example, the dollar price of yen might
dollar relative to the decline from $.01 = ¥1 to $.005 = ¥1. A decrease in the dollar price of yen is called an
currency of another appreciation of the dollar relative to the yen. It means that the international value
nation so that a dol-
lar buys a larger
of the dollar has increased. It then takes fewer dollars (or pennies) to buy a single
amount of the for- yen; the dollar is worth more because it can purchase more yen and therefore more
eign currency. Japanese goods. Each Sony Walkman becomes less expensive in terms of dollars, so
Canadians purchase more of them. In general, Canadian imports rise. Meanwhile,
because it takes more yen to get a dollar, Canadian exports to Japan fall.
Figure 5-5 summarizes these currency relationships. (Key Question 7)
114 Part One • An Introduction to Economics and the Economy

FIGURE 5-5 CURRENCY APPRECIATION AND DEPRECIATION

Suppose the dollar
price of a certain for-
eign currency rises
Dollar price International
(as illustrated by the of foreign value of dollar
upper left arrow). currency falls (dollar
That means the inter- rises Equals depreciates)
national value of the
dollar depreciates
(upper right arrow).
It also means that
the foreign currency
price of the dollar has
declined (lower left Equals Equals
arrow) and that the
international value of
the foreign currency
has appreciated Foreign
(lower right arrow). currency International
price of value of foreign
Equals currency rises
dollar falls
(foreign
currency
appreciates)

● A country has a comparative advantage when it ● An appreciation of the dollar is an increase in

can produce a product at a lower domestic oppor-
tunity cost than can a potential trading partner.
● Specialization based on comparative advantage
increases the total output available for nations
that trade with one another.
● The foreign exchange market is the market in
which the currencies of nations are exchanged
for each other.
the international value of the dollar relative to
the currency of some other nation; a dollar
now buys more units of that currency. A depre-
ciation of the dollar is a decrease in the inter-
national value of the dollar relative to another
currency; a dollar now buys fewer units of that
currency.

Government and Trade

If people and nations benefit from specialization and international exchange, why do
governments sometimes try to restrict the free flow of imports or encourage exports?
protective What kinds of world trade barriers can governments erect, and why would they do so?
tariff A tariff
designed to shield Trade Impediments and Subsidies
domestic producers
of a good or service There are four means by which governments commonly interfere with free trade:
from the competi-
tion of foreign ● Protective tariffs are excise taxes or duties placed on imported goods. Protec-
producers. tive tariffs are designed to shield domestic producers from foreign competi-
 chapter five • canada in the global economy 115

tion. They impede free trade by causing a rise in the prices of imported goods,
thereby shifting demand toward domestic products. An excise tax on imported
shoes, for example, would make domestically produced shoes relatively less
expensive to consumers.
import ● Import quotas are limits on the quantities or total value of specific items that
quota A limit may be imported. Once a quota is “filled,” further imports of that product are
imposed by a choked off. Import quotas are more effective than tariffs in retarding interna-
nation on the
quantity (or total
tional commerce. With a tariff, a product can go on being imported in large
value) of a good quantities; with an import quota, however, all imports are prohibited once the
that may be quota is filled.
imported during
some period of ● Non-tariff barriers (and, implicitly, non-quota barriers) include onerous licens-
time. ing requirements, unreasonable standards pertaining to product quality, or
simply bureaucratic red tape in customs procedures. Some nations require that
non-tariff importers of foreign goods obtain licenses and then restrict the number of
barriers All licenses issued. Although many nations carefully inspect imported agricul-
barriers other than
protective tariffs tural products to prevent the introduction of potentially harmful insects, some
that nations erect countries use lengthy inspections to impede imports.
to impede interna-
tional trade. ● Export subsidies consist of government payments to domestic producers of
export goods. By reducing production costs, the subsidies enable producers to
export sub- charge lower prices and thus to sell more exports in world markets. Two exam-
sidies Govern- ples: Some European governments have heavily subsidized Airbus Industries,
ment payments to
domestic producers
a European firm that produces commercial aircraft, to help Airbus to compete
to enable them to against the U.S. firm Boeing. Canada, the United States, and other nations have
reduce the price of subsidized domestic farmers to boost the domestic food supply. Such subsidies
a good or service have lowered the market price of food, and have artificially lowered export
to foreign buyers. prices on agricultural produce.

Why Government Trade Interventions?

What accounts for the impulse to impede imports, boost exports, and create trade
surpluses through government policy when free trade is beneficial to a nation? Why
would a nation want to send more output abroad for consumption there than it gains
as imported output in return? There are several reasons—some legitimate, most not.

MISUNDERSTANDING OF THE GAINS FROM TRADE

It is a commonly accepted myth that the greatest benefit to be derived from inter-
national trade is greater domestic employment in the export sector. This suggests
that exports are “good” because they increase domestic employment, whereas
imports are “bad” because they deprive people of jobs at home. Actually, the true
benefit created by international trade is the overall increase in output obtained
through specialization and exchange. A nation can fully employ its resources,
including labour, with or without international trade. International trade, however,
enables society to use its resources in ways that increases its total output and there-
fore its overall well-being.
A nation does not need international trade to operate on its production possibil-
ities curve. A closed (non-trading) national economy can have full employment
without international trade. However, through world trade an economy can reach
a point beyond its domestic production possibilities curve. The gain from trade is the
extra output obtained from abroad—the imports obtained for less cost than if they
were produced at home.
116 Part One • An Introduction to Economics and the Economy

POLITICAL CONSIDERATIONS
While a nation as a whole gains from trade, trade may harm particular domestic
industries and particular groups of resource suppliers. In our earlier comparative-
advantage example, specialization and trade adversely affected the Canadian corn
industry and the Mexican soybean industry. Those industries might seek to preserve
their economic positions by persuading their respective governments to protect
them from imports—perhaps through tariffs or import quotas.
Those who directly benefit from import protection are few in number but have
much at stake. Thus, they have a strong incentive to pursue political activity to
achieve their aims. However, the overall cost of tariffs and quotas typically greatly
exceed the benefits. It is not uncommon to find that it costs the public $100,000 or
more a year to protect a domestic job that pays less than half that amount. Moreover,
because these costs are buried in the price of goods and spread out over millions of
citizens, the costs born by each individual citizen is quite small. In the political
arena, the voice of the relatively few producers demand protectionism is loud and
constant, whereas the voice of those footing the bill is soft or non-existent.
Indeed, the public may be won over by the apparent plausibility (“Cut imports
and prevent domestic unemployment”) and the patriotic ring (“Buy Canadian!”) of
the protectionist arguments. The alleged benefits of tariffs are immediate and clear-
cut to the public, but the adverse effects cited by economists are obscure and dis-
persed over the entire economy. When political deal-making is added in—“You
back tariffs for the apparel industry in my province, and I’ll back tariffs on the auto
industry in your province”—the outcome can be a network of protective tariffs,
import quotas, and export subsidies.

Costs to Society
Tariffs and quotas benefit domestic producers of the protected products, but they
harm domestic consumers, who must pay higher than world prices for the protected
goods. They also hurt domestic firms that use the protected goods as inputs in their
production processes. For example, a tariff on imported steel would boost the price
of steel girders, thus hurting firms that construct large buildings. Also, tariffs and
quotas reduce competition in the protected industries. With less competition from
foreign producers, domestic firms may be slow to design and implement cost-
saving production methods and introduce new or improved products.

Multilateral Trade Agreements

and Free-Trade Zones
When one nation enacts barriers against imports, the nations whose exports
suffer may retaliate with trade barriers of their own. In such a trade war, escalating
tariffs choke world trade and reduce everyone’s economic well-being. Economic
historians generally agree that high tariffs were a contributing cause of the Great
Depression. Aware of that fact, nations have worked to lower tariffs worldwide.
Their pursuit of free trade has been added by powerful domestic interest groups:
Exporters of goods and services, importers of foreign components used in “domes-
tic” products, and domestic sellers of imported products all strongly support
lower tariffs.
Figure 5-6 makes clear that while Canada has been a high-tariff nation over much
of its history, Canadian tariffs have declined during the past half-century.
 chapter five • canada in the global economy 117

FIGURE 5-6 CANADIAN TARIFF RATES, 1930–2000

Historically, Canadian

Import duty (percentage of total imports)

25
tariff rates have fluc-
tuated. But beginning GATT (1947)
with the mid-1930s, 20 Kennedy Round
the trend has been of GATT (1967)
downward. (Source:
Adapted from Statis- Tokyo Round
15
tics Canada, “Histori- of GATT (1979)
cal Statistics of Uruguay
Canada,” Catalogue Round
10 of GATT
No. 11-516, and Stat-
can: CANSIM Disc, (1993)
March 2000.)
5

0
1930 40 50 60 70 80 90 2000
Year

Reciprocal Trade Agreements

The specific tariff reductions negotiated between Canada and any particular nation
most- were generalized through most-favoured-nation clauses, which often accompany
favoured- reciprocal trade agreements. These clauses stipulate that any subsequently reduced
nation Canadian tariffs, resulting from negotiation with any other nation, would apply
clause An
agreement by equally to any nation that signed the original agreement. So if Canada negotiates a
Canada to allow reduction in tariffs on wristwatches with, say, France, the lower Canadian tariff on
some other nation’s imported French watches also applies to the imports of the other nations having
exports into Canada most-favoured-nation status, say, Japan and Switzerland. This way, the reductions
at the lowest tariff
in Canadian tariffs automatically applies to many nations.
levied by Canada.

General Agreement on Tariffs and Trade (GATT)

general In 1947, 23 nations, including Canada, signed the General Agreement on Tariffs and
agreement Trade (GATT). GATT was based on three principles: (1) equal, non-discriminatory
on tariffs trade treatment for all member nations; (2) the reduction of tariffs by multilateral
and trade
(gatt) The inter- negotiation; and (3) the elimination of import quotas. Basically, GATT provided a
national agreement forum for the negotiation of reduced trade barriers on a multilateral basis among
reached in 1947 in nations.
which 23 nations Since World War II, member nations have completed eight “rounds” of GATT
agreed to give
negotiations to reduce trade barriers. The eighth and last “round” of negotiations
equal and non-
discriminatory began in Uruguay in 1986. After seven years of wrangling, in 1993 the 128 member
treatment to the nations reached a new agreement. The Uruguay Round agreement took effect on Jan-
other nations, to uary 1, 1995, and its provisions are to be phased in through 2005.
reduce tariff rates Under this agreement, tariffs on thousands of products have been eliminated or
by multinational reduced, with overall tariffs eventually dropping by 33 percent. The agreement also
negotiations, and
to eliminate export liberalized government rules that in the past impeded the global market for such
quotas. services as advertising, legal services, tourist services, and financial services. Quo-
tas on imported textiles and apparel were phased out and replaced with tariffs.
118 Part One • An Introduction to Economics and the Economy

Other provisions reduced agricultural subsidies paid to farmers and protected intel-
lectual property (patents, trademarks, copyrights) against piracy.
When fully implemented, the Uruguay Round agreement will boost the world’s
GDP by an estimated $6 trillion, or 8 percent. Consumers in Canada will save more
than $3 billion annually.

World Trade Organization (WTO)

world trade The Uruguay Round agreement established the World Trade Organization (WTO)
organiza- as GATT’s successor. Some 135 nations belong to the WTO, with China being the last
tion (wto) entrant. The WTO oversees trade agreements reached by the member nations and
An organization
established in 1994,
rules on trade disputes among them. It also provides forums for further rounds of
replacing GATT, to trade negotiations.
oversee the provi- GATT and the WTO have been positive forces in the trend toward liberalized
sions of the Uruguay world trade. The trade rules agreed upon by the member nations provide a strong
Round and resolve and necessary bulwark against the protectionism called for by the special-interest
any disputes stem-
ming from it.
groups in the various nations.
For that reason and others, the WTO is highly controversial. Critics are concerned
that rules crafted to expand international trade and investment enable firms to cir-
cumvent national laws that protect workers and the environment. What good are
minimum-wage laws, worker safety laws, collective bargaining rights, and envi-
ronmental laws, if firms can easily shift their production to nations that have weaker
www.wto.org
laws or consumers can buy goods produced in those countries?
World Trade Proponents of the WTO respond that labour and environmental protections
Organization should be pursued directly in nations that have low standards and via international
organizations other than the WTO. These issues should not be linked to the process
of trade liberalization, which confers widespread economic benefits across nations.
Moreover, say proponents of the WTO, many environmental and labour concerns
european are greatly overblown. Most world trade is among advanced industrial countries,
union (eu) not between them and countries that have lower environmental and labour stan-
An association of dards. Moreover, the free flow of goods and resources raises output and income in
European nations the developing nations. Historically, such increases in living standards have engen-
that has eliminated dered stronger, not weaker, protections for the environment and for workers.
tariffs among them,
established com-
mon tariffs for The European Union (EU)
goods imported
from outside the Countries have also sought to reduce tariffs by creating regional free-trade zones—
member nations, also called trade blocs. The most dramatic example is the European Union (EU), for-
and allowed the merly called the European Economic Community. Initiated as the Common Market
free movement of
labour and capital
in 1958, the EU now comprises 15 Western European nations—France, Germany,
among them. Italy, Belgium, the Netherlands, Luxembourg, Denmark, Ireland, the United King-
dom, Greece, Spain, Portugal, Austria, Finland, and Sweden.
trade bloc
A group of nations THE EU TRADE BLOC
that lower or
abolish trade barri- The EU has abolished tariffs and import quotas on nearly all products traded
ers among mem- among the participating nations and established a common system of tariffs appli-
bers. Examples cable to all goods received from nations outside the EU. It has also liberalized the
include the Euro- movement of capital and labour within the EU and has created common policies in
pean Union and the
nations of the North
other economic matters of joint concern, such as agriculture, transportation, and
American Free business practices. The EU is now a strong trade bloc: a group of countries having
Trade Agreement. common identity, economic interests, and trade rules.
 chapter five • canada in the global economy 119

EU integration has achieved for Europe increased regional specialization, greater

productivity, greater output, and faster economic growth. The free flow of goods
and services has created large markets for EU industries. The resulting economies
of large-scale production have enabled them to achieve much lower costs than they
could have achieved in their small, single-nation markets.
The effects of EU success on non-member nations, such as Canada, have been
mixed. A peaceful and increasingly prosperous EU makes its members better cus-
tomers for Canadian exports. But Canadian firms and other non-member nations’
firms have been faced with tariffs and other barriers that make it difficult for them
to compete against firms within the EU trade bloc. For example, autos produced in
Germany and sold in Spain or France face no tariffs, whereas North American and
Japanese autos sold in those EU countries do. This puts non-EU firms at a serious
disadvantage. Similarly, EU trade restrictions hamper Eastern European exports of
metals, textiles, and farm products, goods that the Eastern Europeans produce in
abundance.
By giving preferences to countries within their free-trade zone, trade blocs such
as the EU tend to reduce their members’ trade with non-bloc members. Thus, the
world loses some of the benefits of a completely open global trading system. Elim-
inating that disadvantage has been one of the motivations for liberalizing global
trade through the World Trade Organization.

THE EURO
One of the most significant recent accomplishments of the EU is the establishment
of the so-called euro zone. In 2002, twelve of the fifteen EU members will share a
euro The com- common currency—the euro. Greece becomes the twelfth member of the euro zone
mon currency used on January 1, 2002, on the same day that the new currency comes into circulation.
by 12 European Great Britain, Denmark, and Sweden have opted out of the common currency, at
nations in the
Euro zone, which
least for now.
includes all nations On January 1, 1999, the euro made its debut for electronic payments, such as
of the European credit card purchases and transfer of funds among banks. On January 1, 2002, euro
Union except Great notes and coins will begin circulating alongside the existing currencies, and on July
Britain, Denmark, 1, 2002, only the euro will be accepted for payment.
and Sweden
Economists expect the euro to raise the standard of living of the euro zone
members over time. By ending the inconvenience and expense of exchanging cur-
rencies, the euro will enhance the free flow of goods, services, and resources among
the euro zone members. It will also enable consumers and businesses to compari-
son shop for outputs and inputs, which will increase competition, reduce prices,
and lower costs.

North American Free Trade Agreement

north In 1993, Canada, Mexico, and the United States formed a major trade bloc. The North
american American Free Trade Agreement (NAFTA) established a free-trade zone that has
free trade about the same combined output as the EU but encompasses a much larger geo-
agreement graphical area. NAFTA has greatly reduced tariffs and other trade barriers between
(nafta) A 1993
agreement estab- Canada, Mexico, and the United States and will eliminate them entirely by 2008.
lishing, over a 15- Critics of NAFTA feared that it would cause a massive loss of Canadian jobs as
year period, a free firms moved to Mexico to take advantage of lower wages and weaker regulations
trade zone com- on pollution and workplace safety. Also, there was concern that Japan and South
posed of Canada,
Mexico, and the
Korea would built plants in Mexico and transport goods tariff-free to Canada, fur-
United States. ther hurting Canadian firms and workers.
120 Part One • An Introduction to Economics and the Economy

In retrospect, the critics were much too pessimistic. Employment has increased in
Canada by more than a million workers since passage of NAFTA, and the unem-
ployment rate has sunk from over 10 percent to under 7 percent. Increased trade
between Canada, Mexico, and the United States has enhanced the standard of liv-
ing in all three countries. (Key Question 11)

● Governments curtail imports and promote ex-
ports through protective tariffs, import quotas,
non-tariff barriers, and export subsidies.
● The General Agreement on Tariffs and Trade
(GATT) established multinational reductions in
tariffs and import quotas. The Uruguay Round
of GATT (1995) reduced tariffs worldwide, liber-
alized international trade in services, strength-
ened protections for intellectual property, and
reduced agricultural subsidies.
● The World Trade Organization (WTO)—GATT’s
successor—rules on trade disputes and pro-
vides forums for negotiations on further rounds
of trade liberalization.
● The European Union (EU) and the North Amer-
ican Free Trade Agreement (NAFTA) have
reduced internal trade barriers among their
members by establishing large free-trade zones.
Twelve of the 15 EU members now have a com-
mon currency—the euro.

Increased Global Competition

Freer international trade has brought intense competition both within Canada and
across the globe. In Canada, imports have gained major shares of many markets,
including those for cars, steel, car tires, clothing, sporting goods, electronics, motor-
cycles, outboard motors, and toys. Nevertheless, hundreds of Canadian firms have
prospered in the global marketplace. Such firms as Nortel have continued to retain
high market shares at home and have dramatically expanded their sales abroad. Of
course, not all Canadian firms have been so successful. Some have not been able to
compete; either because their international competitors make better-quality prod-
ucts or have lower production costs, or both.
Is the heightened competition that accompanies the global economy a good
thing? Although some domestic producers do get hurt and their workers must find
employment elsewhere, foreign competition clearly benefits consumers and society
in general. Imports break down the monopoly power of existing firms, thereby low-
ering product prices and providing consumers with a greater variety of goods. For-
eign competition also forces domestic producers to become more efficient and to
improve product quality; that has already happened in several Canadian industries,
including steel and autos. Most Canadian firms can and do compete quite success-
fully in the global marketplace.
What about those Canadian firms that cannot compete successfully in open mar-
kets? The harsh reality is that they should go out of business, much like an unsuc-
cessful corner boutique. Persistent economic losses mean that scare resources are
not being used efficiently. Shifting those resources to alternative, profitable uses will
increase total Canadian output. It will be far less expensive for Canada to provide
training and, if necessary, relocation assistance to laid-off workers than to try to pro-
tect these jobs from foreign competition.

In The Future and Its Enemies,
Virginia Postrel notes the aston-
ishing fact that if you thoroughly
shuffle an ordinary deck of 52
playing cards, chances are prac-
tically 100 percent that the re-
sulting arrangement of cards
has never before existed. Never.
Every time you shuffle a deck,
you produce an arrangement of
cards that exists for the first time
in history.
The arithmetic works out that
way. For a very small number of
items, the number of possible
arrangements is small. Three
items, for example, can be
arranged only six different ways.
But the number of possible
arrangements grows very large
very quickly. The number of dif-
ferent ways to arrange five items
is 120 . . . for ten items it’s
3,628,800 . . . for fifteen items
it’s 1,307,674,368,000.
The number of different ways
to arrange 52 items is 8.066 ×
1067. This is a big number. No hu-
man can comprehend its enor-
mousness. By way of compari-
son, the number of possible
ways to arrange a mere 20 items
is 2,432,902,008,176,640,000—a
number larger than the total
number of seconds that have
elapsed since the beginning of
time ten billion years ago—and
this number is Lilliputian com-
pared to 8.066 × 1067.
What’s the significance of
these facts about numbers? Con-
sider the number of different re-
chapter five • canada in the global economy
SHUFFLING THE DECK
Economist Donald Boudreaux marvels at the way the
market system systematically and purposefully arranges
the world’s tens of billions of individual resources.
sources available in the world—
my labour, your labour, your land,
oil, tungsten, cedar, coffee beans,
chickens, rivers, the CN Tower,
Windows 2000, the wharves of
Halifax, the classrooms at Ox-
ford, the airport at Tokyo, and on
and on and on. No one can pos-
sibly count all of the different
productive resources available
for our use. But we can be sure
that this number is at least in the
tens of billions.
When you reflect on how
incomprehensibly large is the
number of ways to arrange a
deck containing a mere 52 cards,
the mind boggles at the number
of different ways to arrange all
the world’s resources.
If our world were random—if
resources combined together
haphazardly, as if a giant took
them all into his hands and
tossed them down like so many
[cards]—it’s a virtual certainty
that the resulting combination of
resources would be useless. Un-
less this chance arrangement
were quickly rearranged accord-
ing to some productive logic,
nothing worthwhile would be
produced. We would all starve
to death. Because only a tiny
fraction of possible arrange-
ments serves human ends, any
arrangement will be useless if it
is chosen randomly or with inad-
equate knowledge of how each
and every resource might be
productively combined with each
other.
121
And yet, we witness all
around us an arrangement of
resources that’s productive and
serves human goals. Today’s
arrangement of resources might
not be perfect, but it is vastly su-
perior to most of the trillions
upon trillions of other possible
arrangements.
How have we managed to get
one of the minuscule number
of arrangements that work? The
answer is private property—a
social institution that encour-
ages mutual accommodation.
Private property eliminates
the possibility that resource ar-
rangements will be random, for
each resource owner chooses a
course of action only if it prom-
ises rewards to the owner that
exceed the rewards promised by
all other available courses.
[The result] is a breathtak-
ingly complex and productive
arrangement of countless re-
sources. This arrangement
emerged over time (and is still
emerging) as the result of bil-
lions upon billions of individual,
daily, small decisions made by
people seeking to better employ
their resources and labour in
ways that other people find
helpful.
Source: Abridged from Donald J.
Boudreaux, “Mutual Accommoda-
tion,” Ideas on Liberty, May 2000,
pp. 4–5. Reprinted with permission.
122 Part One • An Introduction to Economics and the Economy
chapter summary
1. Goods and services flows, capital and labour
flows, information and technology flows,
and financial flows link Canada and other
countries.
2. International trade is growing in importance
globally and for Canada. World trade is sig-
nificant to Canada in two respects: (a) Cana-
dian imports and exports as a percentage
of domestic output are significant; and
(b) Canada is completely dependent on trade
for certain commodities and materials that
cannot be obtained domestically.
3. Principal Canadian exports include automo-
tive products, machinery and equipment,
and grain; major Canadian imports are gen-
eral machinery and equipment, automo-
biles, and industrial goods and machinery.
Quantitatively, the United States is our most
important trading partner.
4. Global trade has been greatly facilitated by
(a) improvements in transportation technol-
ogy, (b) improvements in communications
technology, and (c) general declines in tar-
iffs. Although North America, Japan, and the
Western European nations dominate the
global economy, the total volume of trade
has been lifted by the contributions of sev-
eral new trade participants. They include the
Asian economies of Singapore, South Korea,
Taiwan, and China (including Hong Kong),
the Eastern European countries (such as the
Czech Republic, Hungary, and Poland), and
the newly independent countries of the for-
mer Soviet Union (such as Estonia, Ukraine,
and Azerbaijan).
5. Specialization based on comparative advan-
tage enables nations to achieve higher stan-
dards of living through trade with other
countries. A trading partner should special-
ize in products and services for which its
domestic opportunity costs are lowest. The
terms of trade must be such that both
nations can obtain more of some products
via trade than they could obtain by produc-
ing it at home.
6. The foreign exchange market sets exchange
rates between currencies. Each nation’s
imports create a supply of its own currency
and a demand for foreign currencies. The
resulting supply-demand equilibrium sets
the exchange rate that links the currencies of
all nations. Depreciation of a nation’s cur-
rency reduces its imports and increases its
exports; appreciation increases its imports
and reduces its exports.
7. Governments influence trade flows through
(a) protective tariffs, (b) quotas, (c) non-tariff
barriers, and (d) export subsidies. Such
impediments to free trade result from mis-
understandings about the advantages of free
trade and from political considerations. By
artificially increasing product prices, trade
barriers cost Canadian consumers billions of
dollars annually.
8. Most-favoured-nation status allows a nation
to export goods into Canada at its lowest tar-
iff level, then or at any later time.
9. In 1947 the General Agreement on Tariffs
and Trade (GATT) was formed to encourage
non-discriminatory treatment for all mem-
ber nations, to reduce tariffs, and to elimi-
nate import quotas. The Uruguay Round of
GATT negotiations (1993) reduced tariffs and
quotas, liberalized trade in services, reduced
agricultural subsidies, reduced pirating of
intellectual property, and phased out quotas
on textiles.
10. GATT’s successor, the World Trade Organi-
zation (WTO), has 135 member nations. It
implements WTO agreements, rules on trade
disputes between members, and provides
forums for continued discussions on trade
liberalization.
11. Free-trade zones (trade blocs) liberalize trade
within regions but may at the same time
impede trade with non-bloc members. Two
examples of free-trade agreements are the
fifteen-member European Union (EU) and
the North American Free Trade Agreement
(NAFTA), comprising Canada, Mexico, and
the United States. Twelve of the EU nations
have agreed to abandon their national cur-
rencies for a common currency called the
euro.
12. The global economy has created intense for-
eign competition in many Canadian product
markets, but most Canadian firms are able to
compete well both at home and globally.
 chapter five • canada in the global economy 123

terms and concepts

absolute advantage, p. 108
appreciation (of the dollar),
p. 113
comparative advantage,
p. 109
depreciation (of the dollar),
p. 113
euro, p. 119
European Union (EU), p. 118
exchange rate, p. 111
export subsidies, p. 115
foreign exchange market,
p. 111
General Agreement on Tariffs
and Trade (GATT), p. 117
import quota, p. 115
most-favoured-nation clause,
p. 117
multinational corporation,
p. 104
non-tariff barriers, p. 115
North American Free Trade
Agreement (NAFTA), p. 119
protective tariff, p. 114
terms of trade, p. 110
trade bloc, p. 118
World Trade Organization
(WTO), p. 118

study questions
1. Describe the four major economic flows that SOUTH KOREA’S
link Canada with other nations. Provide a PRODUCTION
specific example to illustrate each flow. PRODUCT ALTERNATIVES
Explain the relationships between the top
A B C D E F
and bottom flows in Figure 5-1.
2. How important is international trade to the Radios (in thousands) 30 24 18 12 6 0
Canadian economy? Who is Canada’s most Chemicals (in tonnes) 0 6 12 18 24 30
important trade partner? How can persistent
trade deficits be financed? “Trade deficits CANADA’S
mean we get more merchandise from the PRODUCTION
rest of the world than we provide them PRODUCT ALTERNATIVES
in return. Therefore, trade deficits are eco- A B C D E F
nomically desirable.” Do you agree? Why or
why not? Radios (in thousands) 10 8 6 4 2 0
3. What factors account for the rapid growth of Chemicals (in tonnes) 0 4 8 12 16 20
world trade since World War II? Who are the
major players in international trade today? a. Are comparative-cost conditions such
Who are the “Asian tigers” and how impor- that the two areas should specialize? If
tant are they in world trade? so, what product should each produce?
b. What is the total gain in radio and
4. KEY QUESTION Use the circular flow chemical output that results from this
model (Figure 5-3) to explain how an
specialization?
increase in exports would affect the rev-
enues of domestic firms, the money income c. What are the limits of the terms of trade?
of domestic households, and imports from Suppose actual terms of trade are 1 unit
abroad. Use Figure 5-2 to find the amounts of radios for 11⁄2 units of chemicals and
(in 2000) of Canada’s exports (flow 13) and that 4 units of radios are exchanged for
imports (flow 16) in the circular flow model. 6 units of chemicals. What are the gains
What do these amounts imply for flows 14 from specialization and trade for each
and 15? area?

5. KEY QUESTION The following are
production possibilities tables for South
Korea and Canada. Assume that before spe-
cialization and trade the optimal product mix
for South Korea is alternative B and for
Canada alternative D.
d. Can you conclude from this illustration
that specialization according to compara-
tive advantage results in more efficient
use of world resources? Explain.
6. Suppose that the comparative-cost ratios of
two products—baby formula and tuna fish—
124 Part One • An Introduction to Economics and the Economy
are as follows in the hypothetical nations of
Canswicki and Tunata.
Canswicki: 1 can baby formula ≡ 2 cans
tuna fish
Tunata: 1 can baby formula ≡ 4 cans
tuna fish
In what product should each nation special-
ize? Explain why terms of trade of 1 can baby
formula = 2 1⁄ 2 cans tuna fish would be
acceptable to both nations.
7. KEY QUESTION True or false? “Cana-
dian exports create a demand for foreign
currencies; foreign imports of our goods gen-
erate supplies of foreign currencies.” Explain.
Would a decline in Canadian incomes or a
weakening of Canadian preferences for for-
eign products cause the dollar to depreciate or
appreciate? What would be the effects of that
depreciation or appreciation on our exports
and imports?
8. If the European euro were to decline in value
(depreciate) in the foreign exchange market,
will it be easier or harder for the French to sell
their wine in Canada? If you were planning a
trip to Paris, how would the depreciation of
the euro change the dollar cost of this trip?
9. True or false? “An increase in the Canadian
dollar price of the euro implies that the euro
has depreciated in value.” Explain.
internet application questions
1. Trade Balances with Partner Countries. Sta-
tistics Canada www.statcan.ca/english/Pgdb/
Economy/International/gblec02a.htm sets
out Canadian imports and exports to major
trading partners and areas for the last five
years. Do we have a trading surplus or deficit
with the United States? What about with
Japan and the European Union?
2. Foreign Exchange Rates—the U.S. for
Canadian Dollar. Statistics Canada provides
the exchange rate of the Canadian dollar
against the U.S. dollar for the last five years
10. What measures do governments use to pro-
mote exports and restrict imports? Who
benefits and who loses from protectionist
policies? What is the net outcome for society?
11. KEY QUESTION Identify and state
the significance of each of the following:
(a) WTO; (b) EU; (c) euro; and (d) NAFTA.
What commonality do they share?
12. Explain: “Free-trade zones such as the EU and
NAFTA lead a double life: they can promote
free trade among members, but they pose
serious trade obstacles for non-members.”
Do you think the net effects of trade blocs are
good or bad for world trade? Why? How do
the efforts of the WTO relate to these trade
blocs?
13. Speculate as to why some Canadian firms
strongly support trade liberalization while
other Canadian firms favour protectionism.
Speculate as to why some Canadian labour
unions strongly support trade liberalization
while other Canadian labour unions strongly
oppose it.
14. (The Last Word) What explains why millions
of economic resources tend to get arranged
logically and productively rather than hap-
hazardly and unproductivley?
at www.statcan.ca/english/Pgdb/Economy/
Economic/econ07.htm. Assume you visited
New York City every summer for the last five
years and bought a Coney Island hotdog for
U.S. $5. Convert this amount to Canadian
dollars using the exchange rate for each year
and plot the Canadian dollar price of the
Coney Island hotdog. Has the Canadian dol-
lar appreciated or depreciated against the
U.S. dollar? What was the least amount in
Canadian dollars your Coney Island hotdog
cost? The most?
 SIX

Supply and
Demand:
Elasticities
and
Government-
Set Prices
IN THIS CHAPTER
Y OU WILL LEARN:
The concept of price elasticity of

M
odern market economies rely mainly
demand and how to calculate it.
• on the activities of consumers, busi-
The factors that determine the
price elasticity of demand. nesses, and resource suppliers to
•
The concept of the price elasticity of allocate resources efficiently. Those activities
supply and how to calculate it.
• and their outcomes are the subject of micro-
The cross and income elasticity of
demand and how to calculate them. economics, to which we now turn. We begin
•
Part Two by investigating the behaviours and
To apply the concept of
elasticity to various
decisions of consumers and businesses.
real-world situations.
 chapter six • supply and demand: elasticities and government-set prices 127

In this chapter we extend our previous discussion of demand and supply. First, we
introduce three ideas: price elasticity, the buying and selling responses of consumers
and producers to price changes; cross elasticity, the buying response of consumers of
one product when the price of another product changes; and income elasticity, the
buying response of consumers when their incomes change. Second, we discuss mar-
kets in which government sets maximum or minimum prices.

Price Elasticity of Demand

The law of demand tells us that consumers will buy more of a product when its
price declines and less when its price increases. But how much more or less will
they buy? That amount varies from product to product and over different price
ranges for the same product, and such variations matter. For example, a firm
contemplating a price hike will want to know how consumers will respond. If
they remain highly loyal and continue to buy, the firm’s revenue and profit will
rise, but if consumers defect en masse to other sellers or products, then revenue and
profit will tumble.
The responsiveness (or sensitivity) of consumers to a price change is measured
price by a product’s price elasticity of demand. For some products—for example, restau-
elasticity rant meals—consumers are highly responsive to price changes. Modest price
of demand changes cause very large changes in the quantity purchased. Economists say that
The ratio of the
percentage change
the demand for such products is relatively elastic or simply elastic.
in quantity For other products—for example, salt—consumers pay much less attention to
demanded of a price changes. Substantial price changes cause only small changes in the amount
product or resource purchased. The demand for such products is relatively inelastic or simply inelastic.
to the percentage
change in its price;
a measure of the The Price Elasticity Coefficient and Formula
responsiveness of
buyers to a change
Economists measure the degree of price elasticity or inelasticity of demand with the
in the price of a coefficient Ed, defined as
product or resource.
percentage change in quantity demanded of product X
Ed = ᎏᎏᎏᎏᎏᎏᎏ
percentage change in price of product X
The percentage changes in the equation are calculated by dividing the change in
quantity demanded by the original quantity demanded and by dividing the change
in price by the original price. So we can restate the formula as
change in quantity demanded of X change in price of X
Ed = ᎏᎏᎏᎏ ÷ ᎏᎏᎏ
original quantity demanded of X original price of X

USE OF PERCENTAGES
We use percentages rather than absolute amounts in measuring consumer respon-
siveness for two reasons.
First, if we use absolute changes, the choice of units will arbitrarily affect our
impression of buyer responsiveness. To illustrate, if the price of a bag of popcorn at
the local softball game is reduced from $3 to $2, and consumers increase their pur-
chases from 60 to 100 bags, it appears that consumers are quite sensitive to price
changes and, therefore, that demand is elastic. After all, a price change of one unit
has caused a change of 40 units in the amount demanded. But by changing the mon-
etary unit from dollars to pennies (why not?), we find that a price change of 100
units (pennies) causes a quantity change of 40 units. This result may falsely lead us
128 Part Two • Microeconomics of Product Markets

to believe that demand is inelastic. We avoid this problem by using percentage

changes. This particular price decline is 33 percent whether we measure in dollars
($1/$3) or pennies (100¢/300¢).
Second, by using percentages, we can correctly compare consumer responsive-
ness to changes in the prices of different products. It makes little sense to compare
the effects on quantity demanded of a $1 increase in the price of a $10,000 used car
with a $1 increase in the price of a $1 soft drink. Here the price of the used car
increased by .01 percent while the price of the soft drink increased by 100 percent.
We can more sensibly compare consumer responsiveness to price increases by using
some common percentage increase in price for both.

ELIMINATION OF THE MINUS SIGN

<members.tripod.com/ We know from the downsloping demand curve shown in earlier chapters that price
ehibbard/micro/ and quantity demanded are inversely related. Thus, the price elasticity coefficient
elastic.htm> of demand Ed will always be a negative number. As an example, if price declines,
An overview of
elasticities
then quantity demanded will increase, which means that the numerator in our for-
mula will be positive and the denominator negative, yielding a negative Ed. For an
increase in price, the denominator will be positive but the numerator will be nega-
tive, again yielding a negative Ed.
Economists usually ignore the minus sign and simply present the absolute value
elastic of the elasticity coefficient to avoid an ambiguity that might otherwise arise. It can
demand be confusing to say that an Ed of –4 is greater than one of –2. This possible confusion
Product or resource
is avoided when we say an Ed of 4 reveals greater elasticity than one of 2. So, in what
demand whose
price elasticity is follows, we ignore the minus sign in the coefficient of price elasticity of demand and
greater than one; show only the absolute value. Incidentally, the ambiguity does not arise with sup-
the resulting change ply because price and quantity supplied are positively related.
in quantity
demanded is greater
than the percentage Interpretation of Ed
change in price.
We can interpret the coefficient of price elasticity of demand as follows.
inelastic
demand ELASTIC DEMAND
Product or resource
demand for which Demand is elastic if a specific percentage change in price results in a larger
the price elasticity percentage change in quantity demanded. Then Ed will be greater than one. For
coefficient is less example, suppose that a 2 percent decline in the price of cut flowers results in a
than one; the 4 percent increase in quantity demanded. Demand for cut flowers is elastic and
resulting percentage
change in quantity
Ed = .04/.02 = 2.
demanded is less
than the percentage INELASTIC DEMAND
change in price.
If a specific percentage change in price produces a smaller percentage change in
unit quantity demanded, demand is inelastic. Ed will be less than one. For example, sup-
elasticity pose that a 2 percent decline in the price of coffee leads to only a 1 percent increase
Demand or supply in quantity demanded. Demand is inelastic and Ed = .01/.02 = .5.
for which the elas-
ticity coefficient is
equal to one; the UNIT ELASTICITY
percentage change The case separating elastic and inelastic demands occurs when a percentage change
in the quantity in price and the resulting percentage change in quantity demanded are the same.
demanded or sup-
plied is equal to the
For example, suppose that a 2 percent drop in the price of chocolate causes a 2 per-
percentage change cent increase in quantity demanded. This special case is termed unit elasticity
in price. because Ed is exactly one, or unity. In this example, Ed = .02/.02 = 1.
 chapter six • supply and demand: elasticities and government-set prices 129

EXTREME CASES
perfectly When we say demand is inelastic, we do not mean that consumers are completely
inelastic unresponsive to a price change. In that extreme situation, when a price change
demand results in no change whatsoever in the quantity demanded, economists say that
Product or resource
demand in which demand is perfectly inelastic. The price elasticity coefficient is zero because there
price can be of any is no response to a change in price. Approximate examples include a diabetic’s
amount at a particu- demand for insulin or an addict’s demand for heroin. A line parallel to the vertical
lar quantity of the axis, such as D1 in Figure 6-1(a), shows perfectly inelastic demand graphically.
product or resource Conversely, when we say demand is elastic, we do not mean that consumers are
demanded; quantity
demanded does not completely responsive to a price change. In that extreme situation, when a small price
respond to a reduction causes buyers to increase their purchases from zero to all they can obtain,
change in price. the elasticity coefficient is infinite (= ∞), and economists say demand is perfectly elas-
tic. A line parallel to the horizontal axis, such as D2 in Figure 6-1(b), shows perfectly
perfectly elastic demand. You will see in Chapter 9 that such a demand applies to a firm—say,
elastic
demand a raspberry grower—that is selling its product in a purely competitive market.
Product or resource
demand in which Refinement: Midpoint Formula
the quantity
demanded can be of Unfortunately, an annoying problem arises in computing the price elasticity coeffi-
any amount at a par- cient. To understand this problem and its solution, consider the hypothetical
ticular product price. demand data for movie tickets in Table 6-1. To calculate Ed for, say, the $5 to $4 price
range, which price–quantity combination should we use as a point of reference? We
have two choices—the $5–4-unit combination and the $4–5-unit combination—and
our choice will influence the outcome. (In this case, each unit represents 1000 tick-
ets; 2 units is 2000, 3 units is 3000, etc.)

FIGURE 6-1 PERFECTLY INELASTIC AND PERFECTLY

ELASTIC DEMAND
Demand curve D1 in P
panel (a) represents
perfectly inelastic D1
demand (Ed = 0). A Perfectly
inelastic
price increase does demand
not change the quan- (Ed = 0)
tity demanded.
Demand curve D2 in
panel (b) represents 0 Q
perfectly elastic
demand. A price (a) Perfectly inelastic demand
increase causes
quantity demanded
to decline from an P
infinite amount to
zero (Ed = ∞). D2

Perfectly
elastic
demand
( Ed = ∞)

0 Q
(b) Perfectly elastic demand
 130 Part Two • Microeconomics of Product Markets

TABLE 6-1 PRICE ELASTICITY OF DEMAND FOR MOVIE

TICKETS AS MEASURED BY THE ELASTICITY
COEFFICIENT AND THE TOTAL-REVENUE TEST
(1) (2) (3) (4) (5)
Total quantity Price Elasticity Total revenue Total-revenue
demanded per week per unit coefficient, Ed (1) × (2) test
(thousands)

1 $8 $ 8,000
5.00 Elastic
2 7 14,000
2.60 Elastic
3 6 18,000
1.57 Elastic
4 5 20,000
1.00 Unit elastic
5 4 20,000
0.64 Inelastic
6 3 18,000
0.38 Inelastic
7 2 14,000
0.20 Inelastic
8 1 8,000

For the $5–4-unit reference point, the price change is from $5 to $4, so the per-
centage decrease in price is 20 percent; the quantity change is from four to five units,
so the percentage increase in quantity is 25 percent. Substituting in the formula, we
<www.findarticles.com/ get Ed = 25/20, or 1.25, indicating that demand is somewhat elastic.
m0VEY/8_25/61410375/ For the $4–5-unit reference point, the price change is from $4 to $5, making the
p1/article.jhtml>
percentage increase in price 25 percent; the quantity change is from five to four
An example of why
elasticity is crucial units, or a 20 percent decline in quantity. The elasticity coefficient is therefore 20/25,
in determining or 0.80, meaning that demand for tickets is slightly inelastic. Which is it? Is the
price levels hypothetical demand for movie tickets elastic or inelastic?
A solution to this problem is to use averages of the two ticket prices and two
quantities as the reference point. For the same $5 to $4 price range, the price refer-
ence is $4.50, and the quantity reference is 4.5 units. The percentage change in price
is now $1/$4.50, or about 22 percent, and the percentage change in quantity is
1/4.50, or also about 22 percent, providing an Ed of 1. This solution estimates elas-
ticity at the midpoint of the relevant price range. We can now state the midpoint for-
mula for Ed as
change in quantity change in price
Ed = ᎏᎏᎏ ÷ ᎏᎏ
sum of quantities/2 sum of prices/2
Substituting data for the $5 to $4 price range, we get
1 1
Ed = ᎏ ÷ ᎏ = 1
9/2 9/2
This result indicates that a price of $4.50 and a 4.5-unit midpoint, the price elastic-
ity of demand is unity. Here a 1 percent price change would result in a 1 percent
change in quantity demanded.
As an exercise, verify the elasticity coefficients for the $1 to $2 and $7 to $8 ticket
price ranges in Table 6-1. The interpretation of Ed for the $1 to $2 range is that a 1 per-
cent change in price will change quantity demanded by 0.20 percent. For the $7 to $8
range, a 1 percent change in price will change quantity demanded by 5 percent.
 chapter six • supply and demand: elasticities and government-set prices 131

Graphical Analysis
We used the hypothetical data for movie tickets in columns 1 and 2 of Table 6-1 to
plot the demand curve D in Figure 6-2(a). The curve illustrates that elasticity typi-
cally varies over the different price ranges of the same demand schedule or curve.
For all straight-line and most other demand curves, demand is more elastic toward

FIGURE 6-2 THE RELATION BETWEEN PRICE ELASTICITY OF

DEMAND FOR MOVIE TICKETS AND TOTAL REVENUE
Demand curve D in
panel (a) is based $8P8 Elastic
on Table 6-1 and is a Ed > 1
marked to show that 7P7
the hypothetical c b
weekly demand for 6P6 Unit
elastic
movie tickets is elas- Ed = 1
Price 5P5
tic at higher price
ranges and inelastic 4P4
at lower price ranges. Inelastic
The total-revenue 3P3 Ed < 1
curve TR in panel
(b) is derived from 2P2
f
demand curve D. 1P1
When price falls g h D
and TR increases,
demand is elastic; 0 Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8
when price falls and 1 2 3 4 5 6 7 8
TR is unchanged, Quantity demanded (thousands)
demand is unit elas-
tic; when price falls (a) Demand curve
and TR declines,
demand is inelastic.

20
Total revenue (thousands of dollars)

18

16

14

12

10

6
TR
4

0 1 2 3 4 5 6 7 8
Quantity demanded
(b) Total-revenue curve
132 Part Two • Microeconomics of Product Markets

the upper left (the $5 to $8 price range of D) than toward the lower right (the $4 to
$1 price range of D).
This difference is the consequence of arithmetic properties of the elasticity meas-
ure. Specifically, in the upper left segment of the demand curve, the percentage
change in quantity is large because the original reference quantity is small. Similarly,
the percentage change in price is small in that segment because the original refer-
ence price is large. The relatively large percentage change in quantity divided by the
relatively small change in price yields a large Ed—an elastic demand.
The reverse holds true for the lower right segment of the demand curve. Here the
total percentage change in quantity is small because the original reference quantity is
revenue (tr) large; similarly, the percentage change in price is large because the original reference
The total number of price is small. The relatively small percentage change in quantity divided by the rel-
dollars received by atively large percentage change in price results in a small Ed—an inelastic demand.
a firm from the sale
of a product; equal
The demand curve in Figure 6-2(a) also illustrates that the slope of a demand
to the total expendi- curve—its flatness or steepness—is not a sound basis for judging elasticity. The
tures for the prod- catch is that the slope of the curve is computed from absolute changes in price and
uct produced by the quantity, while elasticity involves relative or percentage changes in price and quan-
firm and equal to tity. The demand curve in Figure 6-2(a) is linear, which by definition means that the
the quantity sold
(demanded) multi-
slope is constant throughout, but we have demonstrated that such a curve is elastic
plied by the price at in its high-price ($8 to $5) range and inelastic in its low-price ($4 to $1) range. (Key
which it is sold. Question 2)

● Price elasticity of demand measures the sensi-
tivity of consumers to changes in the price of a
product.
● The price elasticity of demand coefficient Ed is
the ratio of the percentage change in quantity
demanded to the percentage change in price.
The averages of the prices and quantities are
used as references in calculating the percentage
changes.
● When Ed is greater than one, demand is elastic;
when Ed is less than one, demand is inelastic;
when Ed is equal to one, demand is unit elastic.
● Demand is typically elastic in the high-price
(low-quantity) range of the demand curve and
inelastic in the low-price (high-quantity) range
of the curve.

total- The Total-Revenue Test

revenue The importance of elasticity for firms relates to the effect of price changes on total
test A test to
determine elasticity revenue and thus on profits (total revenue minus total costs).
of demand between Total revenue (TR) is the total amount the seller receives from the sale of a prod-
any two prices: uct in a particular period; it is calculated by multiplying the product price (P) by the
Demand is elastic quantity demanded and sold (Q). In equation form, TR = P × Q. Total revenue and
if total revenue the price elasticity of demand are related. Indeed, perhaps the easiest way to infer
moves in the oppo-
site direction as whether demand is elastic or inelastic is to employ the total-revenue test, which
price; it is inelastic looks at what happens to total revenue when product price changes.
when it moves in
the same direction ELASTIC DEMAND
as price; and it is
unit elastic when it If demand is elastic, a decrease in price will increase total revenue. Even though a
does not change lesser price is received per unit, enough additional units are sold to more than com-
when price changes. pensate for the lower price. For an example, look at demand curve D in Figure 6-2(a),
chapter six • supply and demand: elasticities and government-set prices 133

specifically the elastic-demand region at the upper left. (Disregard Figure 6-2(b) for
the moment.) At point a on the curve, price is $8 and quantity demanded is 1 unit, or
1000 tickets. So total revenue, or price times quantity, is $8000 (= $8 × 1000 tickets).
If the price of movie tickets declines to $7 (point b), the quantity demanded
becomes 2 units, and total revenue is $14,000 (= $2 × 7000 units). As a result of the
price decline from $8 to $7, total revenue has increased from $8000 to $14,000. This
increase has occurred because the loss in revenue from the lower price per unit is
less than the gain in revenue from the larger quantity demanded at the lower price.
Specifically, the $1 price reduction applies to the original 1000 tickets (Q1), for a loss
of $1000, but the lower price increases quantity demanded by 1000 tickets (Q1 to Q2),
with a resulting gain in revenue of $7000. Thus, the movie theatre achieves a net
increase in total revenue of $6000 (= $7000 – $1000).
The reasoning is reversible: If demand is elastic, a price increase will reduce total
revenue. If we shift from b to a on the demand curve, the gain in total revenue
caused by the higher ticket price is less than the loss in revenue from the drop in
sales. Combining these results tells us that demand is elastic if a price change causes
total revenue to change in the opposite direction.

INELASTIC DEMAND
If demand is inelastic, a price decrease will reduce total revenue. The modest
increase in ticket sales will not offset the decline in revenue per unit, and the net
result is that total revenue will decline. To see this, look toward the lower right of
demand curve D in Figure 6-2(a), specifically the inelastic-demand region. At point
f on the curve, price is $2 and quantity demanded is 7000 tickets. So total revenue is
$14,000. If the price drops to $1 (point h), quantity demanded increases to 8000 tick-
ets. Total revenue becomes $8000, which is clearly less than $14,000. Total revenue
has declined because the loss of revenue from the lower unit price is larger than the
gain in revenue from the accompanying increase in sales. The $1 decline in price
applies to 7000 tickets, with a consequent revenue loss of $7000. The sales increase
accompanying that lower price is 1000 tickets, which results in a revenue gain of
$1000. The overall result is a net decrease in total revenue of $6000 (= $1000 – $7000).
Again, our analysis is reversible: If demand is inelastic, a price increase will
increase total revenue. Together, these results tell us that demand is inelastic if a
price change causes total revenue to change in the same direction.

UNIT ELASTICITY
In the special case of unit elasticity, an increase or a decrease in price leaves total
revenue unchanged. The loss in revenue from a lower unit price is exactly offset by
the gain in revenue from the accompanying increase in sales. Conversely, the gain
in revenue from a higher unit price is exactly offset by the revenue loss associated
with the accompanying decline in the amount demanded.
In Figure 6-2(a) we find that at the $5 price, 4000 tickets will be sold, yielding total
revenue of $20,000. At $4, 5000 tickets will be sold, again resulting in $20,000 of total
revenue. The $1 price reduction causes the loss of $4000 in revenue on the 4000 tick-
ets that could have been sold for $5 each. This loss is exactly offset by a $4000 rev-
enue gain resulting from the sale of 1000 more tickets at the lower $4 price.

Price Elasticity and the Total-Revenue Curve

In Figure 6-2(b) we graphed the total revenue per week to the theatre owner that
corresponds to each price–quantity combination indicated along demand curve D
134 Part Two • Microeconomics of Product Markets

in Figure 6-2(a). The price–quantity demanded combination represented by point a

on the demand curve yields total revenue of $8000 (= $8 × 1000 tickets). In Figure 6-
2(b), we graphed this $8 amount vertically at one unit (1000 tickets) demanded. Sim-
ilarly, the price–quantity demanded combination represented by point b in the
upper panel yields total revenue of $14,000 (= $7 × 2000 tickets). This amount is
graphed vertically at two units (2000 tickets) demanded in the lower panel. The ulti-
mate result of such graphing is total-revenue curve TR that first slopes upward, then
reaches a maximum, and finally turns downward.
Comparison of curves D and TR sharply focuses the relationship between elas-
ticity and total revenue. Lowering the ticket price in the elastic range of demand—
for example, from $8 to $5—increases total revenue. Conversely, increasing the
ticket price in that range reduces total revenue. In both cases, price and total revenue
change in opposite directions, confirming that demand is elastic.
The $5 to $4 price range of demand curve D reflects unit elasticity. When price
either decreases from $5 to $4 or increases from $4 to $5, total revenue remains
$20,000. In both cases, price has changed and total revenue has remained constant,
confirming that demand is unit elastic when we consider these particular price
changes.
In the inelastic range of demand curve D, lowering the price—for example, from
$4 to $1—decreases total revenue, as shown in Figure 6-2(b). Raising the price boosts
total revenue. In both cases, price and total revenue move in the same direction, con-
firming that demand is inelastic.
Here again is the total-revenue test. Note what happens to total revenue when the
price of a product changes. If total revenue changes in the opposite direction from
price, demand is elastic. If total revenue changes in the same direction as price,
demand is inelastic. If total revenue does not change when price changes, demand
is unit elastic.
Table 6-2 summarizes the characteristics of price elasticity of demand. You should
review it carefully. (Key Questions 4 and 5)

TABLE 6-2 PRICE ELASTICITY OF DEMAND: A SUMMARY

Impact on total revenue of a
Absolute value of
elasticity coefficient Demand is Description Price increase Price decrease

Greater than 1 Elastic or Quantity demanded Total revenue Total revenue

(Ed > 1) relatively elastic changes by a larger decreases increases
percentage than
does price
Equal to 1 (Ed = 1) Unit or unitary Quantity demanded Total revenue Total revenue
elastic changes by the is unchanged is unchanged
same percentage
as does price
Less than 1 (Ed < 1) Inelastic or Quantity demanded Total revenue Total revenue
relatively inelastic changes by a smaller increases decreases
percentage than
does price
chapter six • supply and demand: elasticities and government-set prices 135

Determinants of Price Elasticity of Demand

We cannot say just what will determine the price elasticity of demand in each indi-
vidual situation. However, the following generalizations are often helpful.

SUBSTITUTABILITY
Generally, the larger the number of substitute goods that are available, the greater the price
elasticity of demand. We will see later that in a purely competitive market, where by
definition many perfect substitutes exist for the product of any specific seller, the
demand curve seen by that single seller is perfectly elastic. If one competitive seller
of carrots or potatoes raises its price, buyers will turn to the readily available per-
fect substitutes provided by its many rivals. Similarly, we would expect the lower-
ing of world trade barriers to increase the elasticity of demand for most products by
making more substitutes available. With unimpeded foreign trade, Mercedes and
BMWs become effective substitutes for domestic Cadillacs and Lincolns. At the
other extreme, we saw earlier that the diabetic’s demand for insulin is highly inelas-
tic because no close substitutes exist.
The elasticity of demand for a product depends on how narrowly the product is
defined. Demand for Reebok sneakers is more elastic than is the overall demand for
shoes. Many other brands are readily substitutable for Reebok sneakers, but there
are few, if any, good substitutes for shoes.

PROPORTION OF INCOME
Other things equal, the higher the price of a good relative to consumers’ incomes, the
greater the price elasticity of demand. A 10 percent increase in the price of relatively
low-priced pencils or chewing gum amounts to a few pennies, and quantity
demanded will probably decline only slightly. Thus, price elasticity for such low-
priced items tends to be low. But a 10 percent increase in the price of relatively high-
priced automobiles or housing means additional expenditures of perhaps $6000 or
$70,000, respectively. These price increases are significant fractions of the annual
incomes and budgets of most families, and quantities demanded will likely dimin-
ish significantly. Price elasticity for such items tends to be high.

LUXURIES VERSUS NECESSITIES

In general, the more that a good is considered a luxury rather than a necessity, the greater
is the price elasticity of demand. Bread and electricity are generally regarded as neces-
sities; it is difficult to get along without them. A price increase will not significantly
reduce the amount of bread consumed or the amount of lighting and power used in
a household. (Note the very low price elasticity coefficient of these goods in Table
6-3.) In an extreme example, a person does not decline an operation for acute
appendicitis because the surgeon has found a way to extra-bill.
However, travel vacations and jewellery are luxuries, which, by definition, can
easily be forgone. If the prices of travel vacations or jewellery rise, a consumer need
not buy them and will suffer no greater hardship without them.
What about the demand for a common product like salt? It is highly inelastic on
three counts: few good substitutes are available, salt is a negligible item in the fam-
ily budget, and salt is a necessity rather than a luxury.

TIME
Generally, product demand is more elastic the longer the period under consideration. Con-
sumers often need time to adjust to changes in prices. For example, when the price
136 Part Two • Microeconomics of Product Markets

TABLE 6-3 SELECTED PRICE ELASTICITIES OF DEMAND*

Coefficient of price Coefficient of price
Product or service elasticity of demand, Ed Product or service elasticity of demand, Ed

Newspapers .10 Milk .63

Electricity (household) .13 Household appliances .63
Bread .15 Movies .87
Major league baseball tickets .23 Beer .90
Telephone service .26 Shoes .91
Sugar .30 Motor vehicles 1.14
Eggs .32 Beef 1.27
Legal services .37 China, glassware, tableware 1.54
Automobile repair .40 Restaurant meals 2.27
Clothing .49 Lamb and mutton 2.65
Gasoline .60
*Compiled from numerous studies and sources reporting price elasticity of demand.

of a product rises, it takes time to find and experiment with other products to see
whether they are acceptable. Consumers may not immediately reduce their pur-
chases very much when the price of beef rises by 10 percent, but in time they may
switch to chicken or fish.
Another consideration is product durability. Studies show that short-run demand
for gasoline is more inelastic (Ed = .2) than is long-run demand (Ed = .7). In the short
run, people are stuck with their present cars and trucks, but with rising
gasoline prices, they will eventually replace them with smaller, more fuel-efficient
vehicles.
Table 6-3 shows estimated price elasticity coefficients for several products. Each
coefficient reflects some combination of the elasticity determinants just discussed.
As an exercise, select two or three of them and explain how they relate to the deter-
minants. (Key Question 6)

● When the price of a good changes, total rev-
enue will change in the opposite direction if
demand for the good is price elastic, in the
same direction if demand is price inelastic, and
not at all if demand is unit elastic.
● Price elasticity of demand is greater (1) the
larger the number of substitutes available,
(2) the higher the price of a product relative to
one’s budget, (3) the greater the extent to which
the product is a luxury, and (4) the longer the
period involved.

Applications of Price Elasticity of Demand

The concept of price elasticity of demand has great practical significance, as the fol-
lowing examples suggest.
 chapter six • supply and demand: elasticities and government-set prices 137

LARGE CROP YIELDS

The demand for most farm products is highly inelastic; Ed is perhaps .20 or .25. As
a result, increases in the output of farm products arising from a good growing sea-
son or from increased productivity tend to depress both the prices of farm products
and the total revenues (incomes) of farmers. For farmers as a group, the inelastic
demand for their product means that a large crop may be undesirable. For policy-
makers it means that achieving the goal of higher total farm income requires that
farm output be restricted.

SALES TAXES
The government pays attention to elasticity of demand when it selects goods and
services on which to levy sales taxes. If a $1 tax is levied on a product and 10,000
units are sold, tax revenue will be $10,000 (= $1 × 10,000 units sold). If the govern-
ment raises the tax to $1.50 but the higher price reduces sales to 5000 because of elas-
tic demand, tax revenue will decline to $7500 (= $1.50 × 5000 units sold). Because a
higher tax on a product with elastic demand will bring in less tax revenue, legisla-
tures tend to seek out products that have inelastic demand—such as liquor, gaso-
line, and cigarettes—when levying sales tax.

DECRIMINALIZATION OF ILLEGAL DRUGS

<www.drugwarfacts.org/ In recent years proposals to legalize drugs have been widely debated. Proponents
economi.htm> contend that drugs should be treated like alcohol; they should be made legal for
The drug war and
adults and regulated for purity and potency. The current war on drugs, it is argued,
economics
has been unsuccessful and the associated costs—including enlarged police forces, the
construction of more prisons, an overburdened court system, and untold human
costs—have increased markedly. Some contend that legalization would reduce drug
trafficking significantly by taking the profit out of it. Crack cocaine and heroin, for
example, are cheap to produce and could be sold at low prices in legal markets.
Because the demand of addicts is highly inelastic, the amounts consumed at the lower
prices would increase only modestly. Addicts’ total expenditures for cocaine and
heroin would decline and so would the street crime that finances those expenditures.
Opponents of legalization say that the overall demand for cocaine and heroin is
far more elastic than proponents think. In addition to the inelastic demand of
addicts, another market segment’s demand is relatively elastic. This segment con-
sists of the occasional users or dabblers, who use hard drugs when the prices are low
but who abstain or substitute, say, alcohol when the prices of hard drugs are high.
Thus, the lower prices associated with the legalization of hard drugs would increase
consumption by dabblers. Also, removal of the legal prohibitions against using
drugs might make drug use more socially acceptable, increasing the demand for
cocaine and heroin.
Many economists predict that the legalization of cocaine and heroin would
reduce street prices by up to 60 percent, depending on whether and how much it
was taxed. According to a recent study, price declines of that size would increase the
number of occasional users of heroin by 54 percent and the number of occasional
users of cocaine by 33 percent. The total quantity of heroin demanded would rise
by an estimated 100 percent and the quantity of cocaine demanded would rise by
50 percent.1 Many existing and first-time dabblers might eventually become addicts.

1
Henry Saffer and Frank Chaloupka, “The Demand for Illegal Drugs,” Economic Inquiry, July
1999, pp. 401–411.
138 Part Two • Microeconomics of Product Markets

The overall result, say the opponents of legalization, would be higher social costs,
possibly including an increase in street crime.

MINIMUM WAGE
The minimum wage prohibits employers from paying workers less than a specified
hourly wage. The minimum wage in Canada ranges from a low of $5.50 in New-
foundland to $8.00 in British Columbia. Critics say that such a minimum wage, if
it is above the equilibrium market wage, moves employers upward along their
downsloping labour demand curves toward lower quantities of labour demanded,
which causes unemployment, particularly among teenage workers. However,
workers who remain employed at the minimum wage receive higher incomes than
they otherwise would. The amount of income lost by the newly unemployed and
the amount of income gained by those who keep their jobs depend on the elasticity
of demand for teenage labour. Research suggests that the demand for teenage
labour is relatively inelastic. If correct, this means that income gains associated with
the minimum wage would exceed income losses. The “unemployment argument”
made by critics of the minimum wage would be stronger if the demand for teenage
workers were elastic.

Price Elasticity of Supply

The concept of price elasticity also applies to supply. If producers are relatively
responsive to price changes, supply is elastic. If they are relatively insensitive to
price changes, supply is inelastic.
We measure the degree of price elasticity or inelasticity of supply with the co-
efficient Es, defined almost like Ed except that we substitute “percentage change in
quantity supplied” for “percentage change in quantity demanded”:
percentage change in quantity supplied of product X
Es = ᎏᎏᎏᎏᎏᎏᎏ
percentage change in price of product X
For reasons explained earlier, the averages, or midpoints, of the before and after
quantities supplied and the before and after prices are used as reference points for
the percentage changes. Suppose an increase in the price of a good from $4 to $6
increases the quantity supplied from 10 units to 14 units. The percentage change in
price would be 2/5, or 40 percent, and the percentage change in quantity would be
4/12, or 33 percent: Es = .33/.40 = .83. In this case, supply is inelastic, since the price
elasticity coefficient is less than one. If Es is greater than one, supply is elastic. If it
price is equal to one, supply is unit elastic. Also, Es is never negative, since price and
elasticity quantity supplied are directly related. Thus, there are no minus signs to drop, as was
of supply The necessary with elasticity of demand.
ratio of the percent- The main determinant of price elasticity of supply is the amount of time pro-
age change in quan-
tity supplied of a ducers have to respond to a change in product price. A firm’s response to, say, an
product or resource increase in the price of Christmas trees depends on its ability to shift resources from
to the percentage the production of other products (whose prices we assume remain constant) to the
change in its price; production of trees. Shifting resources takes time: the longer the time available, the
the responsiveness greater the ability to shift resources. So, we can expect a greater response, and there-
of producers to a
change in the price fore greater elasticity of supply, the longer a firm has to adjust to a price change.
of a product or In analyzing the impact of time on elasticity, economists distinguish among the
resource. immediate market period, the short run, and the long run.
 chapter six • supply and demand: elasticities and government-set prices 139

Price Elasticity of Supply: The Market Period

market The market period is the period that occurs when the time immediately after a
period A change in market price is too short for producers to respond with a change in quan-
period in which tity supplied. Suppose the owner of a small farm brings to market one truckload of
producers of a
product are unable tomatoes, which is the entire season’s output. The supply curve for the tomatoes is
to change the perfectly inelastic (vertical); the farmer will sell the truckload whether the price is
quantity produced high or low. Why? Because the farmer can offer only one truckload of tomatoes even
in response to a if the price of tomatoes is much higher than anticipated. The farmer might like to
change in its price. offer more tomatoes, but tomatoes cannot be produced overnight. Another full
growing season is needed to respond to a higher-than-expected price by producing
more than one truckload. Similarly, because the product is perishable, the farmer
cannot withhold it from the market. If the price is lower than anticipated, the
farmer will still sell the entire truckload.
The farmer’s costs of production, incidentally, will not enter into this decision to
sell. Though the price of tomatoes may fall far short of production costs, the farmer
will nevertheless sell out to avoid a total loss through spoilage. During the market
period, our farmer’s supply of tomatoes is fixed: only one truckload is offered no
matter how high or low the price.
Figure 6-3(a) shows the farmer’s vertical supply curve during the market period.
Supply is perfectly inelastic because the farmer does not have time to respond to a
change in demand, say from D1 to D2. The resulting price increase from P0 to Pm sim-
ply determines which buyers get the fixed quantity supplied; it elicits no increase
in output.
However, not all supply curves need be perfectly inelastic immediately after a
price change. If the product is not perishable and the price rises, producers may
choose to increase quantity supplied by drawing down their inventories of unsold,
stored goods, causing the market supply curve to attain some positive slope. For our

FIGURE 6-3 TIME AND THE ELASTICITY OF SUPPLY

P P P
Sm
Ss

Pm SL
Ps Pl
P0 P0 P0

D2 D2 D2
D1 D1 D1
Q Q Q
0 Qo 0 Qo Qs 0 Qo QI
(a) Immediate market period (b) Short run (c) Long run
The greater the amount of time producers have to adjust to a change in demand, here from D1 to D2, the greater will be their
output response. In the immediate market period in panel (a), producers have insufficient time to change output, and so sup-
ply is perfectly inelastic. In the short run in panel (b), plant capacity is fixed, but changing the intensity of its use can alter
output; supply is therefore more elastic. In the long run in panel (c), all desired adjustments, including changes in plant
capacity, can be made, and supply becomes still more elastic.
140 Part Two • Microeconomics of Product Markets

tomato farmer, the market period may be a full growing season; for producers of
goods that can be inexpensively stored, there may be no market period at all.

Price Elasticity of Supply: The Short Run

short run A In the short run, the plant capacity of individual producers and of the entire industry
period of time in is fixed. Even so, firms do have time to use their fixed plants more or less intensively.
which producers In the short run, our farmer’s plant (land and farm machinery) is fixed, but time is
are able to change
the quantities of
available in the short run to cultivate tomatoes more intensively by applying more
some but not all of labour and more fertilizer and pesticides to the crop. The result is a somewhat greater
the resources they output in response to a presumed increase in demand; this greater output is reflected
employ. in a more elastic supply of tomatoes, as shown by figure Ss in Figure 6-3(b). Note now
that the increase in demand from D1 to D2 is met by an increase in quantity (from Q0
to Qs), so there is a smaller price adjustment (from P0 to Ps) than in the market period.
The equilibrium price is, therefore, lower in the short run than in the market period.

Price Elasticity of Supply: The Long Run

long run A The long run is a period long enough for firms to adjust their plant sizes and for new
period of time long firms to enter (or existing firms to leave) the industry. In the tomato industry, for
enough to enable example, our farmer has time to acquire additional land and buy more machinery
producers of a
product to change
and equipment. Furthermore, other farmers may, over time, be attracted to tomato
the quantities of all farming by the increased demand and higher price. Such adjustments create a larger
the resources they supply response, as represented by the more elastic supply curve SL in Figure 6-3(c).
employ. The outcome is a smaller price rise (P0 to P1) and a larger output increase (Q0 to Q1)
in response to the increase in demand from D1 to D2. (Key Question 10)
There is no total-revenue test for elasticity of supply. Supply shows a positive or
direct relationship between price and amount supplied; the supply curve is upslop-
ing. Regardless of the degree of elasticity or inelasticity, price and total revenue
always move together.

Cross Elasticity and Income

Elasticity of Demand
Price elasticities measure the responsiveness of the quantity of a product demanded
or supplied when its price changes. The consumption of a good also is affected by
cross a change in the price of a related product or by a change in income.
elasticity
of demand
The ratio of the Cross Elasticity of Demand
percentage change
in quantity The cross elasticity of demand measures how sensitive consumer purchases of one
demanded of one product (say, X) are to a change in the price of some other product (say, Y). We cal-
good to the percent- culate the coefficient of cross elasticity of demand Exy just as we do the coefficient of
age change in the
simple price elasticity, except that we relate the percentage change in the consump-
price of some other
good; a positive tion of X to the percentage change in the price of Y:
coefficient indicates
percentage change in quantity demanded of product X
the two products are Exy = ᎏᎏᎏᎏᎏᎏᎏ
substitute goods; a percentage change in price of product Y
negative coefficient
indicates they are
This cross elasticity (or cross price elasticity) concept allows us to quantify
complementary and more fully understand substitute and complementary goods, introduced in
goods. Chapter 3.
 chapter six • supply and demand: elasticities and government-set prices 141

SUBSTITUTE GOODS
If cross elasticity of demand is positive, meaning that sales of X move in the same
direction as a change in the price of Y, then X and Y are substitute goods. An exam-
ple is Kodak film (X) and Fuji film (Y). An increase in the price of Kodak film causes
consumers to buy more Fuji film, resulting in a positive cross elasticity. The larger
the positive cross elasticity coefficient, the greater the substitutability between the
two products.

COMPLEMENTARY GOODS
When cross elasticity is negative, we know that X and Y move together; an increase
in the price of one decreases the demand for the other. They are complementary
goods. For example, an increase in the price of cameras will decrease the amount of
film purchased. The larger the negative cross elasticity coefficient, the greater is the
complementarity between the two goods.

INDEPENDENT GOODS
A zero or near-zero cross elasticity suggests that the two products being considered
are unrelated or independent goods. An example is walnuts and film; we would not
expect a change in the price of walnuts to have any effect on purchases of film, and
vice versa.

APPLICATIONS
The degree of substitutability of products, measured by the cross elasticity coeffi-
cient, is important to businesses and government. For example, suppose that Coca-
Cola is considering whether to lower the price of its Sprite brand. Not only will it
want to know something about the price elasticity of demand for Sprite (will the
price cut increase or decrease total revenue?), it will also be interested in knowing
whether the increased sale of Sprite will come at the expense of its Coke brand. How
sensitive are the sales of one of its products (Coke) to a change in the price of
another of its products (Sprite)? By how much will the increased sales of Sprite can-
nibalize the sales of Coke? A low cross elasticity would indicate that Coke and Sprite
are weak substitutes for each other and a lower price for Sprite would have little
effect on Coke sales.
Government also implicitly uses the idea of cross elasticity of demand in assess-
ing whether a proposed merger between two large firms will substantially reduce
competition and violate the antitrust laws. For example, the cross elasticity between
Coke and Pepsi is high, making them strong substitutes for each other. Conse-
quently, the government would likely block a merger between the two companies
income because it would lessen competition. In contrast, the cross elasticity between film
elasticity and gasoline is low or zero. A merger between Kodak and Petro-Canada would have
of demand a minimal effect on competition, so government would let that merger happen.
The ratio of the
percentage change
in the quantity
demanded of a good Income Elasticity of Demand
to a percentage
change in consumer
Income elasticity of demand measures the degree to which consumers respond to
income; measures a change in their income by buying more or less of a particular good. The coefficient
the responsiveness of income elasticity of demand, Ei, is determined with the formula
of consumer pur-
percentage change in quantity demanded
chases to income Ei = ᎏᎏᎏᎏᎏ
changes. percentage change in income
142 Part Two • Microeconomics of Product Markets

NORMAL GOODS
For most goods, the income elasticity coefficient Ei is positive, meaning that more of
them are demanded as incomes rise. Such goods are called normal or superior
goods, which we first described in Chapter 3. The value of Ei varies greatly among
normal goods. For example, income elasticity of demand for automobiles is about
+3.00, while income elasticity for most farm products is only about +.20.

INFERIOR GOODS
A negative income elasticity coefficient designates an inferior good. Retread tires,
cabbage, long-distance bus tickets, used clothing, and muscatel wine are likely can-
didates. Consumers decrease their purchases of inferior goods as incomes rise.

INSIGHTS
Coefficients of income elasticity of demand provide insights into the economy.
For example, income elasticity helps to explain the expansion and contraction of
industries in Canada. On average, total income in the economy has grown by 2
to 3 percent annually. As income has expanded, industries producing products
for which demand is quite income elastic have expanded their outputs. Thus, auto-
mobiles (Ei = +3), housing (Ei = +1.5), books (Ei = +1.4), and restaurant meals (Ei =
+1.4) have all experienced strong growth of output. Meanwhile, industries pro-
ducing products for which income elasticity is low or negative have tended to
grow slowly or to decline. For example, agriculture (Ei = +.20) has grown far more
slowly than has the economy’s total output. We do not eat twice as much when our
incomes double.
As another example, when recessions occur and people’s incomes decline, gro-
cery stores fare relatively better than stores selling electronic equipment. People do
not substantially cut back on their purchases of food when their incomes fall;
income elasticity of demand for food is relatively low. But they do substantially cut
back on their purchases of electronic equipment; income elasticity on such equip-
ment is relatively high. (Key Questions 12 and 13)
In Table 6-4 we provide a synopsis of the cross elasticity and income elasticity
concepts.

TABLE 6-4 CROSS AND INCOME ELASTICITIES OF DEMAND

Value of coefficient Description Type of good(s)

Cross elasticity:
Positive (Ewz > 0) Quantity demanded of W changes in same direction Substitutes
as change in price of Z
Negative (Exy < 0) Quantity demanded of X changes in opposite direction Complements
from change in price of Y

Income elasticity:
Positive (Ei > 0) Quantity demanded of the product changes in same Normal or
direction as change in income superior
Negative (Ei < 0) Quantity demanded of the product changes in opposite Inferior
direction from change in income
 chapter six • supply and demand: elasticities and government-set prices 143

Elasticity and Taxes

Supply and demand analysis and the elasticity concept are applied repeatedly in the
remainder of this book. Let’s strengthen our understanding of these analytical tools
and their significance by examining elasticity and tax incidence.

Elasticity and Tax Incidence

In Figure 6-4, S and D represent the pretax market for a certain domestic wine from
the Niagara Peninsula. The no-tax equilibrium price and quantity are $4 per bottle
and 15 million bottles. If government levies a tax of $1 per bottle directly on the win-
ery for every bottle sold, who actually pays it?

DIVISION OF BURDEN
Since government places the tax on the sellers (suppliers), the tax can be viewed as
an addition to the marginal cost of the product. Now sellers must get $1 more for
each bottle to receive the same per-unit profit they were getting before the tax. While
sellers are willing to offer, for example, five million bottles of untaxed wine at $2 per
bottle, they must now receive $3 per bottle—$2 plus the $1 tax—to offer the same
five million bottles. The tax shifts the supply curve upward (leftward) as shown in
Figure 6-4, where St is the after-tax supply curve.
The after-tax equilibrium price is $4.50 per bottle, whereas the before-tax price
was $4.00. So, in this case, half the $1 tax is paid by consumers as a higher price; the
other half must be paid by producers in a lower after-tax per-unit revenue. That is,
after paying the $1 tax per unit to the government, producers receive $3.50, or 50¢

FIGURE 6-4 THE INCIDENCE OF A TAX

A tax of a specified P
amount per unit
levied on producers, St
here $1 per unit,
shifts the supply S
curve upward by the $6
amount of the tax per
unit: the vertical dis- Tax $1
Price (per bottle)

tance between S and 5

St. This shift results in
a higher price (here 4
$4.50) to the con-
sumer and a lower
after-tax price (here 3
$3.50) to the pro-
ducer. Thus,
2
consumers and pro-
ducers share the D
burden of the tax in 1
some proportion
(here equally at $.50
per unit). 0
5 10 15 20 25 Q
Quantity
(millions of bottles per month)
 144 Part Two • Microeconomics of Product Markets

less than the $4.00 before-tax price. In this instance, consumers and producers share
the burden of this tax equally; producers shift half the tax to consumers in a higher
price and bear the other half themselves.
Note also that the equilibrium quantity decreases as a result of the tax levy and
the higher price it imposes on consumers. In Figure 6-4, that decline in quantity is
from 15 million bottles per month to 12.5 million bottles per month.

ELASTICITIES
If the elasticities of demand and supply were different from those shown in Figure
6-4, the incidence of tax would also be different. Two generalizations are relevant.
First, with a specific supply, the more inelastic the demand for the product, the larger the
portion of the tax shifted to consumers. To verify this, sketch graphically the extreme
cases where demand is perfectly elastic or perfectly inelastic. In the first case, the
incidence of the tax is entirely on sellers; in the second, the tax is shifted entirely to
consumers.
Figure 6-5 contrasts the more usual cases where demand is either relatively elas-
tic or relatively inelastic in the relevant price range. With elastic demand, shown in
Figure 6-5(a), a small portion of the tax (Pe – P1) is shifted to consumers and most of
the tax (P1 – P2) is borne by the producers. With inelastic demand, shown in Figure
6-5(b), most of the tax (Pi – P1) is shifted to consumers and only a small amount
(P1 – Pb) is paid by producers. In both graphs the per-unit tax is represented by the
vertical distance between St and S.
<economics.about.com/ Note also that the decline in equilibrium quantity (Q1 – Q2) is smaller when
money/economics/library/ demand is more inelastic, which is the basis of our previous applications of the elas-
weekly/aa070897.htm> ticity concept: Revenue-seeking legislatures place heavy excise taxes on liquor, cig-
Some simple economics
of the tobacco deal
arettes, automobile tires, telephone service, and other products whose demands are
thought to be inelastic. Since demand for these products is relatively inelastic, the
tax does not reduce sales much, so the tax revenue stays high.
Second, with a specific demand, the more inelastic the supply, the larger the portion of
the tax borne by producers. When supply is elastic, as in Figure 6-6(a), most of the tax
(Pe – P1) is shifted to consumers, and only a small portion (P1 – Pa) is borne by sell-
ers. But when supply is inelastic, as in Figure 6-6(b), the reverse is true; the major

FIGURE 6-5 DEMAND ELASTICITY AND THE INCIDENCE OF A TAX

Panel (a): If demand P P
St St
is elastic in the rele-
vant price range, Tax S Tax S
price rises modestly
(P1 to Pe) when a tax
is levied. Hence, the Pi a
Pe a
producer bears most
P1 P1
of the tax burden. b b
Panel (b): If demand De Pb
Pa c
is inelastic, the price c
to the buyer will
increase substantially Di
(P1 to Pi) and most of 0 Q1 Q0 Q 0 Q1 Q2 Q
the tax will be shifted
to consumers. (a) Tax incidence and elastic (b) Tax incidence and inelastic
demand demand
 chapter six • supply and demand: elasticities and government-set prices 145

FIGURE 6-6 SUPPLY ELASTICITY AND THE INCIDENCE OF A TAX

Panel (a): With an P P
St S
elastic supply an
excise tax results in a
large price increase St
Tax Tax
(P1 to Pe), and the
tax is therefore paid a
mainly by consumers. Pe
S a
Panel (b): If supply is P1 b Pi
inelastic, the price Pa P1 b
c
rise is small (P1 to Pi), Pb c
and sellers will
have to bear most D
D
of the tax.
0 Q1 Q0 Q 0 Q1 Q0 Q
(a) Tax incidence and elastic (b) Tax incidence and inelastic
supply supply

portion of the tax (P1 – Pb ) falls on sellers, and a relatively small amount (Pi – P1) is
shifted to buyers. The equilibrium quantity also declines less with an inelastic sup-
ply than it does with an elastic supply.
Gold is an example of a product with an inelastic supply, one where the burden
of a tax would mainly fall on producers. Conversely, because the supply of baseballs
is elastic, producers would pass on to consumers much of a tax on baseballs.
You may want to reverse the analysis and assume that the government levies a
(sales) tax on consumers. (Key Question 14)

Government-Set Prices
We turn now to another major supply and demand topic of our chapter: the impli-
cations of government-set prices. On occasion the public and the government con-
clude that supply and demand have resulted in prices that are either unfairly high
to buyers or unfairly low to sellers. In such instances the government may intervene
by legally limiting how high or low a price may go.

Price Ceilings and Shortages

price ceiling A price ceiling is the maximum legal price a seller may charge for a product or serv-
A legally estab- ice. A price at or below the ceiling is legal; a price above it is not. The rationale for
lished maximum establishing price ceilings (or ceiling prices) on specific products is that they pur-
price for a good or
service.
portedly enable consumers to obtain some essential good or service that they could
not afford at the equilibrium price. Examples are rent controls and usury laws,
which specify maximum prices in the forms of rent and interest that can be charged
to borrowers. Also, the government has at times imposed price ceilings either on all
products or on a very wide range of products—so-called price controls—to try to
restrain inflation. Price controls were invoked during World War II and in the 1970s.

GRAPHICAL ANALYSIS
We can easily demonstrate the effects of price ceilings graphically. Let’s suppose
that rapidly rising world income boosts the purchase of automobiles and shifts the
146 Part Two • Microeconomics of Product Markets

demand for gasoline to the right so that the equilibrium or market price reaches
$1.25 per litre, shown as P0 in Figure 6-7. The rapidly rising price of gasoline greatly
burdens low-income and moderate-income households who pressure government
to “do something.” To keep gasoline affordable for these households, the govern-
ment imposes a ceiling price, Pc, of $.75 per litre. To be effective, a price ceiling must
be below the equilibrium price. A ceiling price of $1.50, for example, would have no
immediate effect on the gasoline market.
What are the effects of this $.75 ceiling price? The rationing ability of the free
market is rendered ineffective. Because the ceiling price, Pc, is below the market-
clearing price, P0, there is a lasting shortage of gasoline. The quantity of gasoline
demanded at Pc is Qd and the quantity supplied is only Qs; a persistent excess
demand or shortage of amount Qd – Qs occurs.
The important point is that the price ceiling, Pc, prevents the usual market adjust-
ment in which competition among buyers bids up price, inducing more production
and rationing some buyers out of the market. That process would continue until the
shortage disappeared at the equilibrium price and quantity, P0 and Q0.
By preventing these market adjustments from occurring, the price ceiling poses
problems born of the market disequilibrium.

RATIONING PROBLEM
How will the government apportion the available supply, Qs, among buyers who
want the greater amount Qd? Should gasoline be distributed on a first-come, first-
served basis, that is, to those willing and able to get in line the soonest and to stay
in line? Or should gas stations distribute it on the basis of favouritism? Since an
unregulated shortage does not lead to an equitable distribution of gasoline, the gov-
ernment must establish some formal system for rationing it to consumers. One
option is to issue ration coupons, which authorize bearers to purchase a fixed
amount of gasoline per month. The rationing system would entail first the printing
of coupons for Qs litres of gasoline and then the equitable distribution of the
coupons among consumers so that the wealthy family of four and the poor family
of four both receive the same number of coupons.

FIGURE 6-7 A PRICE CEILING RESULTS IN A PERSISTENT

SHORTAGE
A price ceiling is a P
maximum legal price, S
such as Pc, that is
below the equilibrium
price. It results in a
persistent product
shortage, here shown
by the distance $1.25 P0
between Qd and Qs. $.75 Pc Ceiling

Shortage
D

Q
0 Qs Q0 Qd
 chapter six • supply and demand: elasticities and government-set prices
black
markets
Markets in which
products are ille-
gally bought and
sold at prices above
the legal limits.
FIGURE 6-8
In the short run (panel
a) the supply for rental
accommodation is
inelastic. If rent controls
are set at Rc, a shortage
of Q1 – Q2 will occur in
the short run. In the long
run (panel b), supply
becomes more elastic
as landlords are able to
add or withdraw rental
units from the market. In
the long run the shortage
will worsen to Q1 – Q3.
On the black market,
rents of as much as R1
will be charged.
147
BLACK MARKETS
Ration coupons would not prevent a second problem from arising. The demand
curve in Figure 6-7 tells us that many buyers are willing to pay more than the ceiling
price Pc, and, of course, it is more profitable for gasoline stations to sell at prices
above the ceiling. Thus, despite the sizable enforcement bureaucracy that will accom-
pany the price controls, black markets in which gasoline is illegally bought and sold
at prices above the legal limits will flourish. Counterfeiting of ration coupons will
also be a problem, and since the price of gasoline is now set by the government, there
would be political pressure on governments to set the price even lower.
RENT CONTROLS
Rent controls are maximum rents established by law (and recently, rent controls
have set maximum rent increases for existing tenants). Such laws are well intended;
their goals are to protect low-income families from escalating rents caused by per-
ceived housing shortages and to make housing more affordable to the poor.
When controls are first imposed, they usually restrict increases in rents above cur-
rent levels. The short-run supply curve for rental accommodation is inelastic
because it takes landlords some time to react to price changes and bring new units
on the market. Most tenants benefit, since the quantity of rental accommodation cur-
rently on the market or under construction is not significantly affected. Thus, the
program appears to be successful even if shortages begin to appear. Figure 6-8 por-
trays a market for rental accommodation with rents fixed at Rc and a short-run sup-
ply curve, Ss. A shortage Q1 – Q2 exists in the short run.
In the long run the shortage of rental accommodation will worsen since the sup-
ply of rental accommodation becomes more elastic. Construction of new units
decreases and landlords try to convert existing units to other uses or allow them to
deteriorate. The supply curve becomes more elastic in the long run, shown by SL in
Figure 6-8(b), making the shortage worse, and increasing it to Q1 – Q3.
The gradually worsening shortage in the long run leads to several related prob-
lems. As in the case of controls on food prices, a black market will emerge. The black
RENT CONTROLS
SS R1 SS SL
R1 R0
Rent (R)
Rent (R)
Rc Rc
Short-run Long-run
shortage D shortage
D
Q2 Q0 Q1 Q3 Q2 Q0 Q1
Quantity of rental accommodation Quantity of rental accommodation
(a) Short run (b) Long run
148 Part Two • Microeconomics of Product Markets

market in rental accommodation is often characterized by the charging of “key

money.” Prospective tenants are often forced to bribe a landlord or a subletting ten-
ant to acquire a particular rental unit. The acceptance of key money is illegal in most
jurisdictions with rent controls, but the practice is difficult to stamp out because it is
to the advantage of both parties. Those desperate for rental accommodation will have
to pay the black market rate of as much as R1, shown in Figure 6-8(b).
Another problem that results from controls is the emergence of a dual rental mar-
ket if new buildings are exempt from controls. Apartment units whose rents are
below market levels are almost always rented informally or with some form of key
money attached. The units that have recently come on the market will be offered at
rents above the levels that would exist without controls as landlords attempt to
compensate for future restrictions on rent increases. Because of discrimination by
landlords and the ability to pay key money, middle-class tenants will find it easier
to secure units in the controlled market, while the poor will be forced to seek units
in the uncontrolled market. Perversely, tenants with higher incomes can be the
major beneficiaries of the program.
Rent controls distort market signals and misallocate resources. Too few resources
are allocated to rental housing, too many to alternative uses. Ironically, although
rent controls are often legislated to lessen the effects of perceived housing shortages,
controls are a primary cause of such shortages.

CREDIT CARD INTEREST CEILINGS

Over the years there have been many calls for interest-rate ceilings on credit card
accounts. The usual rationale for interest-rate ceilings is that the banks and retail
stores issuing such cards are presumably taking unfair advantage of users and, in par-
ticular, lower-income users by charging interest rates that average about 18 percent.
What might be the responses to government imposing a below-equilibrium interest
rate on credit cards? The lower interest income associated with a legal interest ceiling
would require the issuers of cards to reduce their costs or enhance their revenues:
● Card issuers might tighten credit standards to reduce losses due to non-
payment and collection costs. Then, low-income people and young people
who have not yet established their creditworthiness would find it more diffi-
cult to obtain credit cards.
● The annual fee charged to cardholders might be increased, as might the fee
charged to merchants for processing credit card sales. Similarly, card users
might be charged a fee for every transaction.
● Card users now have a post-purchase grace period during which the credit
provided is interest-free. That period might be shortened or eliminated.
● Certain “enhancements” that accompany some credit cards (for example,
extended warranties on products bought with a card) might be eliminated.
● Retail stores that issue their own cards might increase their prices to help off-
set the decline of interest income; customers who pay cash would in effect be
subsidizing customers who use credit cards.

price Price Floors and Surpluses

floors Legally
determined prices
Price floors are minimum prices fixed by the government. A price at or above the
above equilibrium price floor is legal; a price below it is not. Price floors above equilibrium prices are
prices. usually invoked when society believes that the free functioning of the market
 chapter six • supply and demand: elasticities and government-set prices 149

system has not provided a sufficient income for certain groups of resource suppli-
ers or producers. Formerly supported prices for agricultural products and current
minimum wages are two examples of price (or wage) floors. Let’s look at the former.
Suppose the equilibrium price for wheat is $3 per bushel and, because of that low
price, many farmers have extremely low incomes. The government decides to help
by establishing a legal price floor or price support of $4 per bushel.
What will be the effects? At any price above the equilibrium price, quantity sup-
plied will exceed quantity demanded—that is, there will be a persistent excess sup-
ply or surplus of the product. Farmers will be willing to produce and offer for sale
more than private buyers are willing to purchase at the price floor. As we saw with a
price ceiling, an imposed legal price disrupts the rationing ability of the free market.
Figure 6-9 illustrates the effect of a price floor. Suppose that S and D are the sup-
ply and demand curves for corn. Equilibrium price and quantity are P0 and Q0,
respectively. If the government imposes a price floor of Pf, farmers will produce Qs,
but private buyers will purchase only Qd. The surplus is the excess of Qs over Qd.
The government can cope with the surplus resulting from a price floor in only
two ways:
1. It can restrict supply (for example, by asking farmers to agree to take a certain
amount of land out of production) or increase demand (for example, by research-
ing new uses for the product involved). These actions may reduce the difference
between the equilibrium price and the price floor and thereby reduce the size of
the resulting surplus.
2. The government can purchase the surplus output at the $4 price (thereby subsi-
dizing farmers) and store or otherwise dispose of it.

Controversial Tradeoffs
In a free market, the competitive forces match the supply decisions of producers and
the demand decisions of buyers, but price ceilings and floors interfere with such an
outcome. The government must provide a rationing system to handle product

FIGURE 6-9 A PRICE FLOOR RESULTS IN A PERSISTENT SURPLUS

A price floor is a P
minimum legal price, S
such as Pf, which
results in a persistent
product surplus, here Surplus
shown by the hori- Floor
zontal distance $3.00 Pf
between Qs and Qd.

$2.00 P0

0 Qd Q0 Qs Q
150 Part Two • Microeconomics of Product Markets

shortages stemming from price ceilings and devise ways to eliminate product sur-
pluses arising from price floors. Legal maximum and minimum prices thus entail
controversial tradeoffs. The alleged benefits of price ceilings to consumers and price
floors to producers must be balanced against the costs associated with the conse-
quent shortages and surpluses.
Our discussion of price controls, rent controls, and interest-rate ceilings on credit
cards shows that government interference with the market can have unintended,
undesirable side effects. Price controls, for example, create illegal black markets.
Rent controls may discourage housing construction and repair. Instead of protect-
ing low-income families from higher interest charges, interest-rate ceilings may sim-
ply deny credit to those families. For all these reasons, economists generally oppose
government-imposed prices.

● Price elasticity of supply measures the sensitiv-
ity of suppliers to changes in the price of a prod-
uct. The price elasticity of supply coefficient Es
is the ratio of the percentage change in quantity
supplied to the percentage change in price.
The elasticity of supply varies directly with the
amount of time producers have to respond to
the price change.
● The cross elasticity of demand coefficient Exy
is computed as the percentage change in the
quantity demanded of product X divided by the
percentage change in the price of product Y. If
the cross elasticity coefficient is positive, the
two products are substitutes; if it is negative,
they are complements.
● The income elasticity coefficient Ei is computed
as the percentage change in quantity de-
manded divided by the percentage change in
income. A positive coefficient indicates a nor-
mal or superior good. The coefficient is nega-
tive for an inferior good.
● Government-controlled prices in the form of
ceilings and floors stifle the rationing function
of prices and cause unintended side effects.

A MARKET FOR HUMAN ORGANS?

Advances in medical technology
make it possible for surgeons to
replace some human body parts
with donated used parts, much
like a mechanic might replace a
worn-out alternator in an auto-
mobile with one from a junked
vehicle. It has become increas-
ingly commonplace in medicine
to transplant kidneys, lungs, liv-
A market might eliminate the present shortage of
human organs for transplant. But many serious
objections exist to turning human body parts into
commodities for purchase and sale.
ers, eye corneas, pancreases, adequate supply of donated or-
and hearts from deceased indi- gans causes an estimated 400
viduals to those whose organs Canadian deaths per year.
have failed or are failing. But
surgeons and many of their pa- Why Shortages? Seldom, if
tients face a growing problem: ever, do we hear of shortages of
too few donated organs are used auto parts such as alterna-
available for transplant. Not tors, batteries, transmissions, or
everyone who needs a trans- water pumps. What is different
plant can get one. Indeed, an in- about organs for transplant?
 chapter six • supply and demand: elasticities and government-set prices
One difference is that a market
exists for used auto parts but
not for human organs. To under-
stand this situation, observe the
demand curve D 1 and supply
curve S1 in the accompanying
figure. The downward slope of
the demand curve tells us that if
there were a market for human
organs, the quantity of organs
demanded would be greater at
lower prices than at higher
prices. Perfectly inelastic supply
curve S 1 represents the fixed
quantity of human organs now
donated via consent before
death. Because the price of these
donated organs is in effect zero,
quantity demanded, Q3, exceeds
quantity supplied, Q1. The short-
age of Q 3 – Q 1 is rationed
through a waiting list of those
in medical need of transplants.
Many people die while still on
the waiting list.
Use of a Market A market for
human organs would increase
the incentive to donate organs.
Such a market might work like
this: An individual might specify
in a legal document a willing-
ness to sell one or more usable
human organs on death or brain
death. The person could specify
where the money from the sale
would go, for example, to family,
a church, an educational institu-
tion, or a charity. Firms would
then emerge to purchase organs
and resell them where needed
for profit. Under such a system,
the supply curve of usable or-
gans would take on the normal
upward slope of typical supply
curves. The higher the expected
price of an organ, the greater the
number of people willing to
have their organs sold at death.
Suppose that the supply curve is
S2 in the figure. At the equilib-
rium price P1, the number of or-
gans made available for trans-
plant (Q 2 ) would equal the
number purchased for trans-
plant (also Q2). In this general-
ized case, the shortage of organs
would be eliminated and, of par-
ticular importance, the number
of organs available for trans-
planting would rise from Q1 to
Q2. More lives would be saved
and enhanced than is the case
under the present donor system.
Objections In view of this posi-
tive outcome, why is there no
such market for human organs?
Critics of market-based solutions
have two main objections. The
first is a moral objection: Critics
feel that turning human organs
into commodities commercial-
izes human beings and dimin-
ishes the special nature of
P ply being driven underground.
S1 S2
P1
D1
P0
Q1 Q2 Q3 Q
151
human life. They say there is
something unseemly about sell-
ing and buying body organs as if
they were bushels of wheat or
ounces of gold. Moreover, critics
note that the market would ra-
tion the available organs (as rep-
resented by Q2 in the figure) to
people who either can afford
them (at P1) or have health insur-
ance for transplants.
Second, a health cost objec-
tion suggests that a market for
body organs would greatly in-
crease the cost of health care.
Rather than obtaining freely do-
nated (although too few) body
organs, patients would have to
pay market prices for them,
increasing the cost of medical
care. As transplant procedures
are further perfected, the de-
mand for transplants is expected
to increase significantly. Rapid
increases in demand relative to
supply would boost the prices of
human organs and thus further
contribute to the problem of es-
calating health care costs.
Supporters of market-based
solutions to organ shortages
point out that the market is sim-
Worldwide, an estimated $1 bil-
lion annual illegal market in
human organs has emerged. As
in other illegal markets, the
unscrupulous tend to thrive.
Those who support legalization
say that it would be greatly
preferable to legalize and regu-
late the market for the laws
against selling transplantable
human organs.
152 Part Two • Microeconomics of Product Markets

chapter summary
1. Price elasticity of demand measures con-
sumer response to price changes. If con-
sumers are relatively sensitive to price
changes, demand is elastic. If they are rela-
tively unresponsive to price changes, de-
mand is inelastic.
2. The price elasticity coefficient Ed measures the
degree of elasticity or inelasticity of demand.
The coefficient is found by the formula
percentage change in
Ed = quantity demanded of X
ᎏᎏᎏᎏ
percentage change in price of X
Economists use the averages of prices and
quantities under consideration as reference
points in determining percentage changes
in price and quantity. If Ed is greater than
one, demand is elastic. If Ed is less than one,
demand is inelastic. Unit elasticity is the spe-
cial case in which Ed equals one.
3. Perfectly inelastic demand is graphed as a
line parallel to the vertical axis; perfectly
elastic demand is shown by a line above and
parallel to the horizontal axis.
4. Elasticity varies at different price ranges on a
demand curve, tending to be elastic in the
upper left segment and inelastic in the lower
right segment. Elasticity cannot be judged by
the steepness or flatness of a demand curve.
5. If total revenue changes in the opposite
direction from prices, demand is elastic. If
price and total revenue change in the same
direction, demand is inelastic. Where demand
is of unit elasticity, a change in prices leaves
total revenue unchanged.
6. The number of available substitutes, the size
of an item’s price relative to one’s budget,
whether the product is a luxury or a neces-
sity, and the time given to adjust are all
determinants of elasticity of demand.
7. The elasticity concept also applies to supply.
The coefficient of price elasticity of supply is
found by the formula
percentage change in
Es = quantity supplied of X
ᎏᎏᎏᎏ
percentage change in price of X
The averages of the price and quantities
under consideration are used as reference
points for computing percentage changes.
Elasticity of supply depends on the ease of
shifting resources between alternative uses,
which in turn varies directly with the time
producers have to adjust to a particular price
change.
8. Cross elasticity of demand indicates how
sensitive the purchase of one product is to
changes in the price of another product. The
coefficient of cross elasticity of demand is
found by the formula
percentage change in
Exy = quantity demanded of X
ᎏᎏᎏᎏ
percentage change in price of Y
Positive cross elasticity of demand identifies
substitute goods; negative cross elasticity
identifies complementary goods.
9. Income elasticity of demand indicates the
responsiveness of consumer purchases to a
change in income. The coefficient of income
elasticity of demand is found by the formula
percentage change in
Ei = quantity demanded of X
ᎏᎏᎏᎏ
percentage change in income
The coefficient is positive for normal goods
and negative for inferior goods.
10. Legally fixed prices stifle the rationing func-
tion of equilibrium prices. Effective price
ceilings result in persistent product short-
ages, and if an equitable distribution of the
product is sought, government must ration
the product to consumers. Price floors lead
to product surpluses; the government must
either purchase these surpluses or eliminate
them by imposing restrictions on production
or by increasing private demand.

terms and concepts

price elasticity of demand,
p. 127
elastic demand, p. 128
inelastic demand, p. 128
unit elasticity, p. 128
perfectly inelastic demand,
p. 129
perfectly elastic demand,
p. 129
total revenue (TR), p. 132
total-revenue test, p. 132
price elasticity of supply,
p. 138
market period, p. 139
short run, p. 140
 chapter six • supply and demand: elasticities and government-set prices
long run, p. 140 income elasticity of demand,
cross elasticity of demand, p. 141
p. 140 price ceiling, p. 145
study questions
1. Explain why the choice between discussing
1, 2, 3, 4, 5, 6, 7, and 8 units or 1000, 2000,
3000, 4000, 5000, 6000, 7000, and 8000
movie tickets makes no difference in deter-
mining elasticity in Table 6-1.
2. KEY QUESTION Graph the accompa-
nying demand data and then use the mid-
point formula for E d to determine price
elasticity of demand for each of the four pos-
sible $1 price changes. What can you con-
clude about the relationship between the
slope of a curve and its elasticity? Explain in
a nontechnical way why demand is elastic in
the northwest segment of the demand curve
and inelastic in the southeast segment.
Product price Quantity demanded
$5 1 illustrate it graphically.
4 2
3 3
2 4
1 5
3. Draw two linear demand curves parallel to
one another. Demonstrate that for any spe-
cific price change, demand is more elastic on
the curve closer to the origin.
4. KEY QUESTION Calculate total-
revenue data from the demand schedule in
question 2. Graph total revenue below your
demand curve. Generalize about the rela-
tionship between price elasticity and total
revenue.
5. KEY QUESTION How would the fol-
lowing changes in price affect total revenue?
That is, would total revenue increase,
decline, or remain unchanged?
a. Price falls and demand is inelastic.
b. Price rises and demand is elastic.
c. Price rises and supply is elastic.
d. Price rises and supply is inelastic.
e. Price rises and demand is inelastic.
f. Price falls and demand is elastic.
g. Price falls and demand is unit elastic.
153
black markets, p. 147
price floors, p. 148
6. KEY QUESTION What are the major
determinants of price elasticity of demand?
Use those determinants and your own rea-
soning in judging whether demand for each
of the following products is probably elastic
or inelastic: (a) bottled water, (b) toothpaste,
(c) Crest toothpaste, (d) ketchup, (e) dia-
mond bracelets, (f) Microsoft Windows oper-
ating system.
7. What effect would a rule stating that univer-
sity students must live in university dormito-
ries have on the price elasticity of demand
for dormitory space? What impact might this
in turn have on room rates?
8. “If the demand for farm products is highly
price inelastic, a large crop yield may reduce
farm incomes.” Evaluate this statement and
9. You are chairperson of a provincial tax com-
mission responsible for establishing a pro-
gram to raise new revenue through sales
taxes. Would elasticity of demand be impor-
tant to you in determining on which prod-
ucts the taxes should be levied? Explain.
10. KEY QUESTION In November 1998
Vincent van Gogh’s self-portrait sold at auc-
tion for $71.5 million. Portray this sale in a
demand and supply diagram and comment
on the elasticity of supply. Comedian George
Carlin once mused, “If a painting can be
forged well enough to fool some experts,
why is the original so valuable?” Provide an
answer.
11. Because of a legal settlement over state
health care claims, in 1999 the tobacco com-
panies had to raise the average price of a
pack of cigarettes from $1.95 to $2.45. The
projected decline in cigarette sales was 8
percent. What does this imply about the
elasticity of demand for cigarettes? Explain.
12. KEY QUESTION Suppose the cross
elasticity of demand for products A and B is
+3.6 and for products C and D is –5.4. What
can you conclude about how products A and
B are related? products C and D?
13. KEY QUESTION The income elastici-
ties of demand for movies, dental services,
154 Part Two • Microeconomics of Product Markets
and clothing have been estimated to be +3.4,
+1.0, and +0.5, respectively. Interpret these
coefficients. What does it mean if an income
elasticity coefficient is negative?
14. KEY QUESTION What is the incidence
of a tax when demand is highly inelastic?
highly elastic? What effect does the elasticity
of supply have on the incidence of a tax?
15. A recent study found that an increase in the
price of beer would reduce the amount of
marijuana consumed. Is cross elasticity of
demand between the two products positive
or is it negative? Are these products substi-
internet application questions
1. Generally, the elasticity of demand for a
product will be greater (a) the larger the
number of substitutes, (b) the greater the
proportion of income an item takes, and
(c) the less the item is considered to be a
necessity. Kmart, <www.kmart.com>, posts a
weekly sales circular on selected merchan-
dise, organized by department. It must con-
clude that the demand for these Blue Light
Specials is elastic: the decrease in price will
increase total revenue. Check out this week’s
specials and, for each item, give it one point
for meeting the criterion of each determinant
tutes, or are they complements? What might
be the logic behind this relationship?
16. Why is it desirable for price ceilings to
be accompanied by government rationing?
Why is it desirable for price floors to be
accompanied by programs that purchase
surpluses, restrict output, or increase de-
mand? Show graphically why price ceilings
produce shortages and price floors cause
surpluses.
17. (The Last Word) Do you favour the estab-
lishment of a market for donated human
organs? Why or why not?
above. How many specials score a three? Do
any score zero? Why would Kmart include
any item that scored less than a three?
2. Rent controls in Ontario began in the 1970s.
The Tenant Act was revised in the late 1990s.
Visit the Ontario Rental Housing Information
Web site at <www.rental-housing.com/canada/
ontpage.htm> to see a summary of existing
laws. What would be the likely attitude of
each of the following groups toward the rent
stabilization program: current renters, people
looking for an apartment to rent in Ontario?
 SEVEN

The Theory
of Consumer
Choice
f you were to compare the shopping carts

I of almost any two consumers, you would

observe striking differences. Why does

Paula have potatoes, peaches, and Pepsi in

IN THIS CHAPTER her cart while Sam has sugar, saltines, and 7-
Y OU WILL LEARN: Up in his? Why didn’t Paula also buy pasta

The two explanations and plums? Why didn’t Sam have soup and
for why the demand curve
is downward sloping. spaghetti on his grocery list?
• In this chapter, you will see how individual
The theory of consumer choice.
• consumers allocate their income among the
About utility maximization and
various goods and services available to them.
the demand curve.
• Given a particular budget, how does a con-
To apply marginal utility
theory to real-world situations. sumer decide what goods and services to buy?

Why does the typical consumer buy more of a

product when its price falls? As we answer

these questions, you will also strengthen your

understanding of the law of demand.

156 Part Two • Microeconomics of Product Markets

A Closer Look at the Law of Demand

The law of demand is based on common sense. A high price discourages consumers
from buying; a low price encourages them to buy. In Chapter 3 we mentioned two
explanations of the downward-sloping demand curve (income and substitution
effects and the law of diminishing marginal utility) that supported this observation.
We now want to say more about these explanations in the context of consumer
behaviour, the subject of this chapter. A third explanation, based on indifference
curves, is more advanced and is summarized in the appendix to this chapter.

Income and Substitution Effects

Our first explanation of the downward slope of the demand curve involves the
income and substitution effects.

THE INCOME EFFECT

income The income effect is the impact that a change in a product’s price has on a consumer’s
effect A real income and, consequently, on the quantity of that good demanded. Let’s suppose
change in the our product is a coffee drink such as a latte or cappuccino. If the price of such drinks
quantity demanded
of a product that
declines, the real income or purchasing power of anyone who buys them increases; that
results from the is, they are able to buy more with the same nominal income. The increase in real income
change in real will be reflected in increased purchases of many normal goods, including coffee drinks.
income (purchasing For example, with a constant money income of $20 every two weeks, you can buy
power) produced by 10 coffee drinks at $2 each. If their price falls to $1 apiece and you buy 10 of them,
a change in the
product’s price.
you will have $10 per week left over to buy more coffee drinks and other goods. A
decline in the price of coffee drinks increases consumers’ real income, enabling them
substitu- to purchase more coffee drinks. This relationship is the income effect.
tion effect
A change in the THE SUBSTITUTION EFFECT
quantity demanded
of a consumer good
The substitution effect is the impact that a change in a product’s price has on its rel-
that results from a ative expensiveness, and, consequently, on the quantity demanded. When the price
change in its of a product falls, that product becomes cheaper relative to all other products. Con-
relative expensive- sumers will substitute the cheaper product for other products that are now rela-
ness produced by a tively more expensive. In our example, if the prices of other products remain
change in the
product’s price, or
unchanged and the price of coffee drinks falls, lattes and cappuccinos become more
the effect of a attractive to the buyer. Coffee drinks are a relatively better buy at $1 than at $2. The
change in the price lower price will induce the consumer to substitute coffee drinks for some of the now
of a resource on the relatively less attractive items in the budget—perhaps colas, bottled water, or iced
quantity of the tea. Because a lower price increases the relative attractiveness of a product, the con-
resource employed
by a firm, assuming
sumer buys more of it. This relationship is the substitution effect.
no change in its The income and substitution effects combine to increase a consumer’s ability and
output. willingness to buy more of a specific good when its price falls.

Law of Diminishing Marginal Utility

Choosing
A second explanation of the downward-sloping demand curve is that, although con-
a Little More sumer wants in general may be insatiable, wants for particular commodities can be
or Less
satisfied. In a specific span of time over which consumers’ tastes remain unchanged,
consumers can get as much of a particular good or service as they can afford. But,
the more of that product they obtain, the less additional product they want.
Consider durable goods, for example. Consumers’ desires for an automobile,
when they have none, may be very strong, but the desire for a second car is less
 chapter seven • the theory of consumer choice 157

intense, and for a third or fourth, weaker and weaker. Unless they are collectors,
even the wealthiest families rarely have more than a half-dozen cars, although their
income would allow them to purchase a whole fleet of vehicles.

TERMINOLOGY
Evidence indicates that consumers can fulfill specific wants with succeeding units
of a commodity but that each added unit provides less utility than the previous unit
utility The purchased. Recall that a product has utility if it can satisfy a want: utility is want-
want-satisfying satisfying power. The utility of a good or service is the satisfaction or pleasure one
power of a good gets from consuming it. Three characteristics of this concept must be emphasized:
or service; the
satisfaction or 1. “Utility” and “usefulness” are not synonymous. Paintings by Picasso may
pleasure a consumer offer great utility to art connoisseurs but are useless functionally (other than
obtains from the
for hiding a crack in a wall).
consumption of a
good or service. 2. Implied in the first characteristic is the fact that utility is subjective. The utility
of a specific product may vary widely from person to person. A jacked-up truck
may have great utility to someone who drives off-road but little utility to some-
one too old to climb into the rig. Eyeglasses have tremendous utility to some-
one who has poor eyesight but no utility at all to a person with 20/20 vision.
3. Because utility is subjective, it is difficult to quantify. But for purposes of illus-
tration, we assume that people can measure satisfaction with units called utils
<www.leavingcert.net/ (units of utility). For example, a particular consumer may get 100 utils of sat-
serve/cont.php3?pg=
EC3DAU0493>
isfaction from a smoothie, 10 utils of satisfaction from a candy bar, and 1 util
A discussion of of satisfaction from a stick of gum. These imaginary units of satisfaction are
demand and utility convenient for quantifying consumer behaviour.

TOTAL UTILITY AND MARGINAL UTILITY

total We must distinguish carefully between total utility and marginal utility. Total utility
utility The is the total amount of satisfaction or pleasure a person derives from consuming some
total amount of specific quantity—for example, 10 units—of a good or service. Marginal utility is the
satisfaction derived
from the consump-
extra satisfaction a consumer realizes from one additional unit of that product, for ex-
tion of a single ample, from the 11th unit. Alternatively, we can say that marginal utility is the change
product or a combi- in total utility that results from the consumption of one more unit of a product.
nation of products. Figure 7-1 (Key Graph) and the accompanying table reveal the relation between
total utility and marginal utility. We have drawn the curves from the data in the
marginal table. Column 2 shows the total utility associated with each level of consumption of
utility The
extra utility a this particular product, tacos; column 3 shows the marginal utility—the change in
consumer obtains total utility—that results from the consumption of each successive taco. Starting at
from the consump- the origin in Figure 7-1(a), we observe that each of the first five units increases total
tion of one addi- utility (TU) but by a diminishing amount. Total utility reaches a maximum at the
tional unit of a good
or service; equal to
sixth unit and then declines.
the change in total So, in Figure 7-1(b) we find that marginal utility (MU) remains positive but dimin-
utility divided by ishes through the first five units (because total utility increases at a declining rate). Mar-
the change in the ginal utility is zero for the sixth unit (because that unit doesn’t change total utility).
quantity consumed. Marginal utility then becomes negative with the seventh unit as the diner becomes ill
(because total utility is falling). Figure 7-1(b) and table column 3 tell us that each suc-
cessive taco yields less extra utility, meaning fewer utils, than the preceding one as the
consumer’s want for tacos comes closer and closer to fulfillment.1 The principle that

1
In Figure 7-1(b) we graphed marginal utility at half-units. For example, we graphed the marginal
utility of 4 utils at 3 1⁄2 units because the 4 utils refers neither to the third nor the fourth unit per se
but to the addition or subtraction of the fourth unit.
158 Part Two • Microeconomics of Product Markets

Key Graph FIGURE 7-1 TOTAL AND MARGINAL UTILITY

Curves TU and MU are graphed from the data in the 30

table. Panel (a): As more of a product is consumed,
total utility increases at a diminishing rate, reaches TU
a maximum, and then declines. Panel (b): Marginal
utility, by definition, reflects the changes in total util-

Total utility (utils)

ity. Thus marginal utility diminishes with increased
20
consumption, becomes zero when total utility is at a
maximum, and is negative when total utility declines.
As shown by the shaded rectangles in panels (a) and
(b), marginal utility is the change in total utility asso-
ciated with each additional taco. Or, alternatively,
each new level of total utility is found by adding 10
marginal utility to the preceding level of total utility.

(1) (2) (3)

Tacos Total Marginal

0 1 2 3 4 5 6 7
consumed utility, utility,
Units consumed per meal
per meal utils utils
(a) Total utility
0 0
Marginal utility (utils)

10
1 10 10
8
2 18 8
6
3 24 6
4
4 28 4
2
5 30 2
0
6 30 0
-2
7 28 -2
MU
1 2 3 4 5 6 7
Units consumed per meal
(b) Marginal utility

Quick Quiz
1. Marginal utility
a. is the extra output a firm obtains when it adds another unit of labour.
b. explains why product supply curves slope upward.
c. typically rises as successive units of a good are consumed.
d. is the extra satisfaction from the consumption of one more unit of some good
or service.
2. Marginal utility in Figure 7-1(b) is positive, but declining, when total util-
ity in Figure 7-1(a) is positive and
a. rising at an increasing rate.
b. falling at an increasing rate.
c. rising at a decreasing rate.
d. falling at a decreasing rate.
3. When marginal utility is zero in panel (b), total utility in panel (a) is
a. also zero.
b. neither rising nor falling.
 chapter seven • the theory of consumer choice 159

c. negative.
d. rising but at a declining rate.
4. Suppose the person represented by these graphs experienced a dimin-
ished taste for tacos. As a result the
a. TU curve would get steeper.
b. MU curve would get flatter.
c. TU and MU curves would shift downward.
d. MU curve, but not the TU curve, would collapse to the horizontal axis.
Answers
1. d; 2. c; 3. b; 4. c

marginal utility declines as the consumer acquires additional units of a given prod-
law of uct is known as the law of diminishing marginal utility. (Key Question 2)
diminishing
marginal MARGINAL UTILITY, DEMAND, AND ELASTICITY
utility As a
consumer increases How does the law of diminishing marginal utility explain why the demand curve
the consumption of for a given product slopes downward? The answer is that, if successive units of a
a good or service, good yield smaller and smaller amounts of marginal, or extra, utility, then the con-
the marginal utility sumer will buy additional units of a product only if its price falls. The consumer for
obtained from each
additional unit of
whom Figure 7-1 is relevant may buy two tacos at a price of $1 each, but because less
the good or service marginal utility is obtained from additional tacos, the consumer will choose not to
decreases. buy more at that price. The consumer would rather spend additional dollars on
products that provide more (or equal) utility, not less utility. Therefore, additional
tacos with less utility are not worth buying unless the price declines. (When mar-
ginal utility becomes negative, the restaurant would have to pay you to consume
another taco!) Thus, diminishing marginal utility supports the idea that price must
decrease for quantity demanded to increase. In other words, consumers behave in
ways that make demand curves downward sloping.
The amount by which marginal utility declines as more units of a product are con-
sumed helps us to determine that product’s price elasticity of demand. Other things
equal, if marginal utility falls sharply as successive units of a product are consumed,
demand is inelastic. A given decline in price will elicit only a relatively small increase
in quantity demanded, since the MU of extra units falls so rapidly. Conversely, mod-
est declines in marginal utility as consumption increases imply an elastic demand. A
particular decline in price will entice consumers to buy considerably more units of
the product, since the MU of additional units declines so slowly.

● The law of demand can be explained in terms
of the income effect (a decline in price raises the
consumer’s purchasing power) and the substi-
tution effect (a product whose price falls is sub-
stituted for other products).
● Utility is the benefit or satisfaction a person
receives from consuming a good or a service.
● The law of diminishing marginal utility indi-
cates that gains in satisfaction become smaller
as successive units of a specific product are
consumed.
● Diminishing marginal utility provides another
rationale for the law of demand, as well as one
for differing price elasticities.
160 Part Two • Microeconomics of Product Markets

Theory of Consumer Choice

Choosing
In addition to explaining the law of demand, the idea of diminishing marginal util-
a Little More ity explains how consumers allocate their money income among the many goods
or Less
and services available for purchase.

Consumer Choice and Budget Constraint

The typical consumer’s situation has the following dimensions.
● Rational behaviour Consumers are rational people who try to use their
money incomes to derive the greatest amount of satisfaction, or utility, from
them. Consumers want to get the most for their money or, technically, to max-
rational imize their total utility. They engage in rational behaviour.
behaviour
Human behaviour ● Preferences Each consumer has clear-cut preferences for certain goods and
based on compari- services of those available in the market. We assume buyers also have a good
son of marginal idea of how much marginal utility they will get from successive units of the
costs and marginal various products they purchase.
benefits; behaviour
designed to ● Budget constraint At any point in time the consumer has a fixed, limited
maximize total amount of money income. Since each consumer supplies a finite amount of
utility.
human and property resources to society, each earns only limited income.
budget Thus, every consumer faces what economists call a budget constraint (budget
constraint limitation), even those who earn millions of dollars a year. Of course, those
The limit that the budget constraints are more severe for consumers with average incomes than
size of a consumer’s
income (and the
for those with extraordinarily high incomes.
prices that must be ● Prices Goods are scarce relative to the demand for them, so every good car-
paid for goods and
services) imposes
ries a price tag. We assume that those price tags are not affected by the
on the ability of that amounts of specific goods that each person buys. After all, each person’s pur-
consumer to obtain chase is a minuscule part of total demand, and since the consumer has a lim-
goods and services. ited number of dollars, each can buy only a limited amount of goods.
Consumers cannot buy everything they want. This point drives home the real-
ity of scarcity to each consumer.
So the consumer must compromise and must choose the most satisfying mix of
goods and services. Different individuals will choose different mixes. As Global Per-
spective 7.1 shows, the mix may vary from nation to nation.

Utility-Maximizing Rule
Of all the different combinations of goods and services consumers can obtain within
their budgets, which specific combination will yield the maximum utility or satis-
faction for each person? To maximize satisfaction, consumers should allocate their
utility- money income so that the last dollar spent on each product yields the same amount of extra
maximizing (marginal) utility. We call this the utility-maximizing rule. When the consumer has
rule To obtain balanced his or her margins using this rule, no incentive exists to alter the expendi-
the greatest utility, ture pattern. The consumer is in equilibrium and would be worse off—total utility
the consumer
would decline—if any alteration occurred in the bundle of goods purchased, pro-
should allocate
money income so viding no change occurs in taste, income, products, or prices.
that the last dollar
spent on each Numerical Example
good or service
yields the same An illustration will help explain the utility-maximizing rule. For simplicity our exam-
marginal utility. ple is limited to two products, but the analysis would apply if there were more.
 chapter seven • the theory of consumer choice 161

7.1

Food expenditures as a percentage

Shares of household of total household expenditures
expenditures spent 0 20 40 60 80
on food, selected
nations High income
Japan
Consumer spending United States
patterns differ not only Canada
individually but also United Kingdom
nationally. One striking Denmark
feature is that household
food expenditures as a Middle income
percentage of total Brazil
household spending Thailand
are much higher in low- Russia
income countries than in Mexico
Argentina
middle-income or high-
income countries.
Low income
Indonesia
Sierra Leone
Vietnam
Madagascar
Tanzania

Source: World Bank. Data are for 1998, <www.worldbank.com>.

Suppose consumer Holly is trying to decide which combination of two products she
should purchase with her fixed daily income of $10. These products might be aspara-
gus and breadsticks, apricots and bananas, or apples and broccoli. Let’s just call them
A and B.
<www.econtools.com/ Holly’s preferences for products A and B and their prices are the basic data deter-
jevons/java/choice/ mining the combination that will maximize her satisfaction. Table 7-1 summarizes
Choice.html> those data, with column 2(a) showing the amount of marginal utility Holly will
Ilustrates utility
maximization subject
derive from each successive unit of A and column 3(a) showing the same thing for
to a budget constraint product B. Both columns reflect the law of diminishing marginal utility, which is
assumed to begin with the second unit of each product purchased.

MARGINAL UTILITY PER DOLLAR

Before applying the utility-maximizing rule to these data, we must put the marginal
utility information in columns 2(a) and 3(a) on a per-dollar-spent basis. Holly’s
choices are influenced not only by the extra utility that successive units of product
A will yield but also by how many dollars (and therefore how many units of alter-
native product B) she must give up to obtain those added units of A.
The rational consumer must compare the extra utility from each product with its
added cost (that is, its price). Suppose you prefer a pizza whose marginal utility is,
162 Part Two • Microeconomics of Product Markets

TABLE 7-1 THE UTILITY-MAXIMIZING COMBINATION OF PRODUCTS

A AND B OBTAINABLE WITH AN INCOME OF $10*
(1) (2) (3)
Unit of product Product A: price = $1 Product B: price = $2

(a) (b) (a) (b)

Marginal utility, Marginal utility Marginal utility, Marginal utility
utils per dollar (MU/price) utils per dollar (MU/price)

First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Fourth 6 6 16 8
Fifth 5 5 12 6
Sixth 4 4 6 3
Seventh 3 3 4 2
*It is assumed in this table that the amount of marginal utility received from additional units of each of the two products is
independent of the quantity of the other product. For example, the marginal-utility schedule for product A is independent of the
amount of B obtained by the consumer.

say, 36 utils to a movie whose marginal utility is 24 utils. But if the pizza’s price is
$12 and the movie costs only $6, you would choose the movie rather than the pizza!
Why? Because the marginal utility per dollar spent would be 4 utils for the movie
(= 24 utils ÷ $6) compared to only 3 utils for the pizza (= 36 utils ÷ $12). You could
buy two movies for $12 and, assuming that the marginal utility of the second movie
is, say, 16 utils, your total utility would be 40 utils. Clearly, 40 units of satisfaction
from two movies are superior to 36 utils from the same $12 expenditure on one pizza.
To make the amounts of extra utility derived from differently priced goods comparable,
marginal utilities must be put on a per-dollar-spent basis. We do this in columns 2(b) and
3(b) by dividing the marginal utility data of columns 2(a) and 3(a) by the prices of
A and B, $1 and $2, respectively.

DECISION-MAKING PROCESS
In Table 7-1 we have Holly’s preferences on a unit basis, and a per-dollar basis, as
well as the price tags of A and B. With $10 to spend, in what order should Holly allo-
cate her dollars on units of A and B to achieve the highest degree of utility within
the $10 limit imposed by her income? What specific combination of A and B will she
have obtained at the time she uses up her $10?
Concentrating on columns 2(b) and 3(b) in Table 7-1, we find that Holly should first
spend $2 on the first unit of B, because its marginal utility per dollar of 12 utils is
higher than A’s 10 utils. Now Holly finds herself indifferent about whether she should
buy a second unit of B or the first unit of A because the marginal utility per dollar of
both is 10 utils. So she buys both of them. Holly now has one unit of A and two units
of B. Also, the last dollar she spent on each good yielded the same marginal utility per
dollar (10 utils), but this combination of A and B does not represent the maximum
amount of utility that Holly can obtain. It cost her only $5 [= (1 × $1) + (2 × $2)], so she
has $5 remaining, which she can spend to achieve a still higher level of total utility.
Examining columns 2(b) and 3(b) again, we find that Holly should spend the next
$2 on a third unit of B because marginal utility per dollar for the third unit of B is
 chapter seven • the theory of consumer choice 163

nine compared with eight for the second unit of A. Now, with one unit of A and
three units of B, she is again indifferent between a second unit of A and a fourth unit
of B because both provide eight utils per dollar. So Holly purchases one more unit
of each. Now the last dollar spent on each product provides the same marginal util-
ity per dollar (eight utils), and Holly’s money income of $10 is exhausted.
The utility-maximizing combination of goods attainable by Holly is two units of A and
four of B. By summing marginal utility information from columns 2(a) and 3(a), we
find that Holly is obtaining 18 (= 10 + 8) utils of satisfaction from the two units of A
and 78 (= 24 + 20 + 18 + 16) utils of satisfaction from the four units of B. Her $10,
optimally spent, yields 96 (= 18 + 78) utils of satisfaction.
Table 7-2, which summarizes our step-by-step process for maximizing Holly’s
utility, merits careful study. Note that we have implicitly assumed that Holly spends
her entire income. She neither borrows nor saves. However, saving can be regarded
as a commodity that yields utility and be incorporated into our analysis. In fact, we
treat it that way in question 4 at the end of this chapter. (Key Question 4)

INFERIOR OPTIONS
Holly can obtain other combinations of A and B with $10, but none will yield as
great a total utility as do two units of A and four of B. As an example, she can obtain
four units of A and three of B for $10. However, this combination yields only 93 utils,
clearly inferior to the 96 utils provided by two units of A and four of B. Furthermore,
other combinations of A and B exist (such as four of A and five of B or one of A and
two of B) in which the marginal utility of the last dollar spent is the same for both
A and B. All such combinations are either unobtainable with Holly’s limited money
income (as four of A and five of B) or do not exhaust her money income (as one of
A and two of B) and, therefore, fail to yield the maximum utility attainable.
As an exercise, suppose Holly’s money income is $14 rather than $10. What is the
utility-maximizing combination of A and B? Are A and B normal or inferior goods?

Algebraic Restatement
Our allocation rule says that a consumer will maximize satisfaction by allocating
money income so that the last dollar spent on product A, the last on product B,
and so forth, yield equal amounts of additional, or marginal, utility. The marginal

TABLE 7-2 SEQUENCE OF PURCHASES TO ACHIEVE CONSUMER

EQUILIBRIUM, GIVEN THE DATA IN TABLE 7-1
Choice Marginal utility
number Potential choices per dollar Purchase decision Income remaining

1 First unit of A 10 First unit of B for $2 $8 = $10 – $2

First unit of B 12
2 First unit of A 10 First unit of A for $1 $5 = $8 – $3
Second unit of B 10 and second unit of B for $2
3 Second unit of A 8 Third unit of B for $2 $3 = $5 – $2
Third unit of B 9
4 Second unit of A 8 Second unit of A for $1 $0 = $3 – $3
Fourth unit of B 8 and fourth unit of B for $2
164 Part Two • Microeconomics of Product Markets

utility per dollar spent on A is indicated by MU of product A divided by the price

of A (column 2(b) in Table 7-1), and the marginal utility per dollar spent on B by MU
of product B divided by the price of B (column 3(b) in Table 7-1). Our utility-
maximizing rule merely requires that these ratios be equal. Algebraically,
MU of Product A MU of Product B
ᎏᎏ = ᎏᎏ
Price of A Price of B
Of course, the consumer must exhaust her available income. Table 7-1 shows us that
the combination of two units of A and four of B fulfills these conditions in that
8 utils 16 utils
ᎏ=ᎏ
$1 $2
and the consumer’s $10 income is spent.
If the equation is not fulfilled, then some reallocation of the consumer’s expen-
ditures between A and B (from the low to the high marginal-utility-per-dollar prod-
uct) will increase the consumer’s total utility. For example, if the consumer spent $10
on four units of A and three of B, we would find that
MU of A: 6 utils MU of B: 18 utils
ᎏᎏ < ᎏᎏ
Price of A: $1 Price of B: $2
Here the last dollar spent on A provides only six utils of satisfaction, and the last
dollar spent on B provides nine (= 18 ÷ $2). So, the consumer can increase total sat-
isfaction by purchasing more of B and less of A. As dollars are reallocated from A to
B, the marginal utility per dollar of A will increase while the marginal utility per dol-
lar of B will decrease. At some new combination of A and B, the two will be equal,
and consumer equilibrium will be achieved. Here, that combination is two units of
A and four of B.

Utility Maximization and the Demand Curve

Once you understand the utility-maximizing rule, you can easily see why product
price and quantity demanded are inversely related. Recall that the basic determi-
nants of an individual’s demand for a specific product are (1) preferences or tastes,
(2) money income, and (3) the prices of other goods. The utility data in Table 7-1
reflect our consumer’s preferences. We continue to suppose that her money income
is $10. Concentrating on the construction of a simple demand curve for product B,
we assume that the price of A, representing other goods, is still $1.

Deriving the Demand Schedule and Curve

We can derive a single consumer’s demand schedule for product B by considering
alternative prices at which B might be sold and then determining the quantity the
consumer will purchase. We have already determined one such price–quantity
combination in the utility-maximizing example: given tastes, income, and prices of
other goods, our rational consumer will purchase four units of B at $2.
Now let’s assume the price of B falls to $1. The marginal-utility-per-dollar data
of column 3(b) in Table 7-1 will double because the price of B has been halved; the
new data for column 3(b) are identical to those in column 3(a), but the purchase of
two units of A and four of B is no longer an equilibrium combination. By applying
the same reasoning we used in the initial utility-maximizing example, we now find
 chapter seven • the theory of consumer choice 165

that Holly’s utility-maximizing combination is four units of A and six units of B. As

summarized in the table in Figure 7-2, Holly will purchase six units of B when the
price of B is $1. Using the data in this table, we can sketch the downward-sloping
demand curve DB shown in Figure 7-2. This exercise, then, clearly links the utility-
maximizing behaviour of a consumer and that person’s demand curve for a partic-
ular product.

Income and Substitution Effects Revisited

At the beginning of this chapter we mentioned that the law of demand can be
understood in terms of the substitution and income effects. Our analysis does not
let us sort out these two effects quantitatively. However, we can see through utility
maximization how each is involved in the increased purchase of product B when the
price of B falls.
To see the substitution effect, recall that before the price of B declined, Holly was
in equilibrium when purchasing two units of A and four units of B in that
MUA(8)/PA($1) = MUB(16)/PB($2). After B’s price falls from $2 to $1, we have
MUA(8)/PA($1) < MUB(16)/PB($1); more simply stated, the last dollar spent on B

FIGURE 7-2 DERIVING AN INDIVIDUAL DEMAND CURVE

At a price of $2 for
product B, the con-
sumer represented
by the data in the
table maximizes utility
by purchasing four $2
units of product B.
The decline in the
Price per unit of B

price of product B
to $1 upsets the
consumer’s initial
utility-maximizing
equilibrium. The con-
sumer restores equi-
1
librium by purchasing
six rather than four
units of product B.
Thus, a simple
price–quantity sched-
ule emerges, which DB
locates two points on
a downward-sloping
demand curve. 0
4 6
Quantity demanded of B

Price per unit of B Quantity demanded

$2 4
1 6
166 Part Two • Microeconomics of Product Markets

now yields more utility (16 utils) than does the last dollar spent on A (8 utils). This
result indicates that a switching of purchases from A to B is needed to restore equi-
librium; that is, a substitution of the now cheaper B for A will occur when the price
of B drops.
What about the income effect? The assumed decline in the price of B from $2 to $1
increases Holly’s real income. Before the price decline, Holly was in equilibrium
when buying two units of A and four of B. At the lower $1 price for B, Holly would
have to spend only $6 rather than $10 on this same combination of goods. She has
$4 left over to spend on more of A, more of B, or more of both. In short, the price
decline of B has caused Holly’s real income to increase so that she can now obtain
larger amounts of A and B with the same $10 of money income. The portion of the
increase in her purchases of B due to this increase in real income is the income effect.
(Key Question 5)

● The theory of consumer behaviour assumes ● We can derive a downward-sloping demand

that, with limited income and a set of product
prices, consumers make rational choices on the
basis of well-defined preferences.
● A consumer maximizes utility by allocating in-
come so that the marginal utility per dollar spent
is the same for every good purchased.
curve by changing the price of one product in
the consumer-behaviour model and noting the
change in the utility-maximizing quantity of that
product demanded.

Applications and Extensions

Many real-world phenomena can be explained by applying the theory of consumer
behaviour.

The Compact Disc Takeover

Compact discs (CDs) made their debut in Canada in 1983. The CD revolutionized
the retail music industry, pushing the vinyl long-playing record (LP) to virtual
extinction. In 1983 fewer than one million CDs were sold in North America com-
pared with almost 210 million LPs. By 1999 some one billion CDs were sold, while
the sales of LPs plummeted to 2.9 million.
This swift turnabout resulted from both price and quality considerations.
Although the price of CDs has not declined significantly, the price of CD players has
nose-dived. Costing $1000 or more a decade ago, most players currently sell for less
than $150. Portable CD players are priced even lower. While CDs and LPs are sub-
stitute goods, CD players and CDs are complementary goods. The lower price for CD
players has expanded their sales and greatly increased the demand for CDs. CDs
hold much more music than LPs and provide a wider range of sound and greater
brilliance of musical tone than LPs.
In terms of our analysis, CD players and CDs have higher ratios of marginal util-
ity to price than do LP players and LPs. The vast majority of consumers have dis-
covered that they can enhance their total utility by substituting CDs for LPs.
 chapter seven • the theory of consumer choice 167

The Diamond–Water Paradox

Early economists such as Adam Smith were puzzled by the fact that some essential
goods had much lower prices than some unimportant goods. Why would water,
essential to life, be priced below diamonds, which have much less usefulness? The
paradox is resolved when we acknowledge that water is in great supply relative to
demand and thus has a very low price per litre. Diamonds, in contrast, are rare and
are costly to mine, cut, and polish. Because their supply is small relative to demand,
their price is very high per caret.
The marginal utility of the last unit of water consumed is very low. The reason
follows from our utility-maximizing rule. Consumers (and producers) respond to
<william- the very low price of water by using a great deal of it for generating electricity, irri-
king.www.drexel.edu/ gating crops, heating buildings, watering lawns, quenching thirst, and so on. Con-
top/prin/txt/MUch/
sumption is expanded until marginal utility, which declines as more water is
Eco412.html>
Adam Smith and the consumed, equals its low price. Conversely, relatively few diamonds are purchased
diamond–water because of their prohibitively high price, meaning that their marginal utility
paradox remains high. In equilibrium
MU of water (low) MU of diamonds (high)
ᎏᎏᎏ = ᎏᎏᎏ
Price of water (low) Price of diamonds (high)
Although the marginal utility of the last unit of water consumed is low and the
marginal utility of the last diamond purchased is high, the total utility of water is
very high and the total utility of diamonds quite low. The total utility derived from
the consumption of water is large because of the enormous amounts of water con-
sumed. Total utility is the sum of the marginal utilities of all the litres of water con-
sumed, including the trillions of litres that have far higher marginal utilities than the
last unit consumed. In contrast, the total utility derived from diamonds is low since
their high price means that relatively few of them are bought. Thus the water–
diamond paradox is solved: water has much more total utility (roughly, usefulness)
than diamonds even though the price of diamonds greatly exceeds the price of
water. These relative prices relate to marginal utility, not total utility.

The Value of Time

The theory of consumer behaviour has been generalized to account for the eco-
nomic value of time. Both consumption and production take time. Time is a valu-
able economic commodity; by using an hour in productive work, a person can
earn $6, $10, $50, or more, depending on education and skills. By using that hour
for leisure or in consumption activities, the individual incurs the opportunity cost
of forgone income and sacrifices the $6, $10, or $50 that could have been earned
by working.
Imagine a self-employed consumer who is considering buying a round of golf on
the one hand, and a concert on the other. The market price of the golf game is $30
and that of the concert is $40, but the golf game takes more time than the concert.
Suppose this consumer spends four hours on the golf course but only two hours at
the concert. If the consumer’s time is worth $10 per hour as evidenced by the $10
wage obtained by working, then the full price of the golf game is $70 (the $30 mar-
ket price plus $40 worth of time). Similarly, the full price of the concert is $60 (the
$40 market price plus $20 worth of time). We find that, contrary to what market
prices alone indicate, the full price of the concert is really less than the full price of
the golf game.
168 Part Two • Microeconomics of Product Markets

If we now assume that the marginal utilities derived from successive golf games
and concerts are identical, traditional theory would indicate that our consumer
should consume more golf games than concerts because the market price of the for-
mer ($30) is lower than that of the latter ($40). When time is taken into account, the
situation is reversed, and golf games ($70) are more expensive than concerts ($60).
So, it is rational for this person to consume more concerts than golf games.
By accounting for time, we can explain certain observable phenomena that tra-
ditional theory does not explain. It may be rational for the unskilled worker or
retiree whose time has little market value to ride a bus from Edmonton to Saska-
toon, but the corporate executive, whose time is very valuable, will find it cheaper
to fly, even though bus fare is only a fraction of plane fare. It is sensible for the
retiree, living on a modest income and having ample time, to spend many hours
shopping for bargains at the mall or taking long trips in a motor home. It is equally
intelligent for the highly paid physician, working 55 hours per week, to buy a new
personal computer over the Internet and take short vacations at expensive resorts.
People in other nations often feel affluent Canadians are wasteful of food and
other material goods but overly economical in their use of time. Canadians who visit
developing countries often feel that time is used casually or squandered, while
material goods are very highly prized and carefully used. These differences are not
a paradox or a case of radically different temperaments; the differences are prima-
rily a rational reflection that the high productivity of labour in an industrially
advanced society gives time a high market value, whereas the opposite is true in a
low-income, developing country.

Cash and Noncash Gifts

Marginal utility analysis also helps us understand why people generally prefer cash
gifts to noncash gifts costing the same amount. The reason is simply that the non-
cash gifts may not match the recipient’s preferences and thus may not add as much
as cash to total utility—consumers know their own preferences better than the gift
giver does and the cash gift provides more choices.
Look back at Table 7-1. Suppose Holly has zero earned income but is given the
choice of a $2 cash gift or a noncash gift of two units of A. Because two units of A
can be bought with $2, these two gifts are of equal monetary value, but by spend-
ing the $2 cash gift on the first unit of B, Holly could obtain 24 utils. The noncash
gift of the first two units of A would yield only 18 (= 10 + 8) units of utility; the non-
cash gifts yields less utility to the beneficiary than the cash gift.
Since giving of noncash gifts is common, considerable value of those gifts is
potentially lost because they do not match their recipients’ tastes. For example, Aunt
Flo may have paid $15 for the Celine Dion CD she gave you for your birthday, but
you would pay only $7.50 for it. Thus, a $7.50, or 50 percent, value loss is involved.
Multiplied by billions spent on gifts each year, the potential loss of value is large.
Some of that loss is avoided by the creative ways individuals handle the problem.
For example, newlyweds set up gift registries for their weddings to help match their
wants to the noncash gifts received. Also, people obtain cash refunds or exchanges
for gifts, so they can buy goods that provide more utility. And people have even
been known to recycle gifts by giving them to someone else at a later time. All three
actions support the proposition that individuals take actions to maximize their
total utility.

Through extension, the theory
of rational consumer behaviour
provides some useful insights on
criminal behaviour. Both the law-
ful consumer and the criminal try
to maximize their total utility (or
net benefit). For example, you
can remove a textbook from the
campus bookstore either by pur-
chasing it or stealing it. If you buy
the book, your action is legal; you
have fully compensated the book-
store for the product. (The book-
store would rather have your
money than the book.) If you
steal the book, you have broken
the law. Theft is outlawed be-
cause it imposes uncompensated
costs on others. In this case, your
action reduces the bookstore’s
revenue and profit and also may
impose costs on other buyers
who now must pay higher prices
for their textbooks.
Why might someone engage
in criminal activity such as steal-
ing? Just like the consumer who
compares the marginal utility of
a good with its price, the poten-
tial criminal compares the mar-
ginal benefit from an action with
the price or cost. If the marginal
benefit (to the criminal) exceeds
the price or marginal cost (also
to the criminal), the individual
undertakes the criminal activity.
Most people, however, do not
engage in theft, burglary, or
fraud. Why not? The answer is
that they perceive the personal
price of engaging in these illegal
activities to be too high relative
to the marginal benefit. That price
or marginal cost to the potential
chapter seven • the theory of consumer choice
CRIMINAL BEHAVIOUR
Although economic analysis is not particularly relevant in
explaining some crimes of passions and violence (for example,
murder and rape), it does provide interesting insights on
such property crimes as robbery, burglary, and auto theft.
criminal has several facets. First,
there are the guilt costs, which
for many people are substantial.
Such individuals would not steal
from others even if there were no
penalties for doing so; their moral
sense of right and wrong would
entail too great a guilt cost rela-
tive to the benefit from the stolen
good. Other types of costs in-
clude the direct costs of the crim-
inal activity (supplies and tools)
and the forgone income from le-
gitimate activities (the opportu-
nity cost to the criminal).
Unfortunately, guilt costs, di-
rect costs, and forgone income
are not sufficient to deter some
people from stealing. So society
imposes other costs, mainly fines
and imprisonment, on lawbreak-
ers. The potential of being fined
increases the marginal cost to the
criminal. The potential of being
imprisoned boosts marginal cost
still further. Most people highly
value their personal freedom and
lose considerable legitimate earn-
ings while incarcerated.
Given these types of costs, the
potential criminal estimates the
marginal cost and benefit of com-
mitting the crime. As a simple ex-
ample, suppose that the direct
cost and opportunity cost of steal-
ing an $80 textbook are both zero.
The probability of getting caught
is 10 percent, and, if appre-
hended, there will be a $500 fine.
The potential criminal will esti-
mate the marginal cost of stealing
the book as $50 (= $500 fine × .10
chance of apprehension). Some-
one who has guilt costs of zero
169
will choose to steal the book be-
cause the marginal benefit of $80
will exceed the marginal cost of
$50. In contrast, someone having
a guilt cost of, say, $40, will not
steal the book. The marginal ben-
efit of $80 will not be as great as
the marginal cost of $90 (= $50 of
penalty cost + $40 of guilt cost).
This perspective on illegal be-
haviour has some interesting
implications. For example, other
things equal, crime will rise
(more of it will be bought) when
its price falls. This explains, for
instance, why some people who
do not steal from stores under
normal circumstances partici-
pate in looting stores during
riots, when the marginal cost
of being apprehended declines
substantially.
Another implication is that
society can reduce unlawful be-
haviour by increasing the price
of crime. It can nourish and in-
crease guilt costs through fam-
ily, educational, and religious ef-
forts. It can increase the direct
costs of crime by using more
sophisticated security systems
(locks, alarms, video surveil-
lance) so that criminals will have
to buy and use more sophisti-
cated tools. It can undertake ed-
ucation and training initiatives
to enhance the legitimate earn-
ings of people who might other-
wise engage in illegal activity.
It can increase policing to raise
the probability of being appre-
hended for crime, and it can im-
pose greater penalties for those
who are caught and convicted.
170 Part Two • Microeconomics of Product Markets

chapter summary
1. The income and substitution effects and the
law of diminishing marginal utility help ex-
plain why consumers buy more of a product
when its price drops and less of a product
when its price increases.
2. The income effect implies that a decline in the
price of a product increases the consumer’s
real income and enables the consumer to buy
more of that product with a fixed money
income. The substitution effect implies that a
lower price makes a product relatively more
attractive and, therefore, increases the con-
sumer’s willingness to substitute it for other
products.
3. The law of diminishing marginal utility states
that, beyond a certain quantity, additional
units of a specific good will yield declining
amounts of extra satisfaction to a consumer.
4. We assume that the typical consumer is
rational and acts based on well-defined pref-
erences. Because income is limited and goods
have prices, consumers cannot purchase all
the goods and services they might want. Con-
sumers therefore select the attainable combi-
nation of goods that maximizes their utility or
satisfaction.
5. A consumer’s utility is maximized when in-
come is allocated so that the last dollar spent
on each product purchased yields the same
amount of extra satisfaction. Algebraically,
the utility-maximizing rule is fulfilled when
MU of product A MU of product B
ᎏᎏᎏ = ᎏᎏᎏ
Price of A Price of B
and the consumer’s total income is spent.
6. The utility-maximizing rule and the demand
curve are logically consistent. Because mar-
ginal utility declines, a lower price is needed
to induce the consumer to buy more of a par-
ticular product.

terms and concepts

income effect, p. 156 marginal utility, p. 157 rational behaviour, p. 160
substitution effect, p. 156 law of diminishing marginal budget contraint, p. 160
utility, p. 157 utility, p. 159 utility-maximizing rule, p. 160
total utility, p. 157

study questions
1. Explain the law of demand through the in- b. “A rational consumer will purchase only
come and substitution effects, using a price one unit of the product represented by
increase as a point of departure. Explain the these data, since that amount maximizes
law of demand in terms of diminishing mar- marginal utility.” Do you agree? Explain
ginal utility. why or why not.
2. KEY QUESTION Complete the follow- c. “It is possible that a rational consumer
ing table and answer the questions below. will not purchase any units of the product
represented by these data.” Do you agree?
Units consumed Total utility Marginal utility Explain why or why not.
0 0 3. Mrs. Wilson buys loaves of bread and litres
1 10 10 of milk each week at prices of $1 and $.80,
respectively. At present she is buying these
2 — 8 two products in amounts such that the mar-
3 25 — ginal utilities from the last units purchased
4 30 — of the two products are 80 and 70 utils,
respectively. Is she buying the utility-
5 — 3
maximizing combination of bread and milk?
6 34 — If not, how should she reallocate her expen-
a. At which rate is total utility increasing: a ditures between the two goods?
constant rate, a decreasing rate, or an in- 4. KEY QUESTION Columns 1 through 4
creasing rate? How do you know? in the table below show the marginal utility,
 chapter seven • the theory of consumer choice 171

measured in utils, that Ricardo would get by
purchasing various amounts of products A,
B, C, and D. Column 5 shows the marginal
utility Ricardo gets from saving. Assume that
the prices of A, B, C, and D are $18, $6, $4,
and $24, respectively, and that Ricardo has
an income of $106.
a. What quantities of A, B, C, and D will
Ricardo purchase in maximizing his utility?
b. How many dollars will Ricardo choose to
save?
c. Check your answers by substituting them
into the algebraic statement of the utility-
maximizing rule.

Column 1 Column 2 Column 3 Column 4 Column 5

Units Units Units Units Number of

of A MU of B MU of C MU of D MU dollars saved MU

1 72 1 24 1 15 1 36 1 5
2 54 2 15 2 12 2 30 2 4
3 45 3 12 3 8 3 24 3 3
4 36 4 9 4 7 4 18 4 2
5 27 5 7 5 5 5 13 5 1
6 18 6 5 6 4 6 7 6 1
⁄2
7 15 7 2 7 3 1⁄ 2 7 4 7 1
⁄4
8 12 8 1 8 3 8 2 8 1
⁄8

5. KEY QUESTION You are choosing b. “It is irrational for an individual to take
between two goods, X and Y, and your mar- the time to be completely rational in eco-
ginal utility from each is as shown below. If nomic decision making.”
your income is $9 and the prices of X and Y c. “Telling Santa what you want for Christ-
are $2 and $1, respectively, what quantities mas makes sense in terms of utility max-
of each will you purchase to maximize utility? imization.”
What total utility will you realize? Assume
that, other things remaining unchanged, the 8. In the past decade or so there has been a
price of X falls to $1. What quantities of X and dramatic expansion of small retail conven-
Y will you now purchase? Using the two prices ience stores (such as Mac’s, 7-Elevens, Beck-
and quantities for X, derive a demand sched- ers), although their prices are generally
ule (price–quantity demanded table) for X. much higher than prices in large supermar-
kets. What explains the success of the con-
venience stores?
Units of X MUx Units of Y MUy
9. Many apartment-complex owners are in-
1 10 1 8 stalling water meters for each apartment and
2 8 2 7 billing the occupants according to the amount
3 6 3 6 of water they use, in contrast to the former
procedure of having a central meter for the
4 4 4 5
entire complex and dividing up the water
5 3 5 4 expense as part of the rent. Where individual
6 2 6 3 meters have been installed, water usage has
declined 10 to 40 percent. Explain that drop,
6. How can time be incorporated into the the- referring to price and marginal utility.
ory of consumer behaviour? Explain the fol-
lowing comment: “Want to make millions of 10. Advanced analysis: A mathematically fair
dollars? Devise a product that saves Canadi- bet is one in which a gambler bets, say, $100,
ans lots of time.” for a 10 percent chance to win $1000 dollars
($100 = .10 × 1000). Assuming diminishing
7. Explain: marginal utility of dollars, explain why this is
a. “Before economic growth, there were too not a fair bet in terms of utility. Why is it even
few goods; after growth, there is too little a less fair bet when the house takes a cut of
time.” each dollar bet? So is gambling irrational?
172 Part Two • Microeconomics of Product Markets
11. Advanced analysis: Let MUA = z = 10 – x and
MUB = z = 21 – 2y, where z is marginal utility
per dollar measured in utils, x is the amount
spent on product A, and y is the amount
spent on product B. Assume that the con-
sumer has $10 to spend on A and B—that is,
x + y = 10. How is the $10 best allocated
between A and B? How much utility will the
marginal dollar yield?
internet application questions
1. The ESPN Sportszone, <wspn.sportzone.com>,
is a major sports information site. Most of the
content is free, but ESPN has a premium
membership (articles marked with IN are only
available through it) for a monthly or an
annual fee. Similar but free sports content
can be found at CNN/Sports Illustrated at
<www.cnnsi.com> and CBS Sports Line at
<cbs.sportsline.com>. Since ESPN has put a
price tag on some of its sports content, it
implies that the utility of a premium member-
ship cannot be found at a free site and is,
therefore, worth the price. Is this the case?
Use the utility maximization rule to justify
12. (The Last Word) In what way is criminal
behaviour similar to consumer behaviour?
Why do most people obtain goods via legal
behaviour as opposed to illegal behaviour?
What are society’s main options for reducing
illegal behaviour?
subscribing or not subscribing to the pre-
mium membership.
2. Assume that you and several classmates
each receive a $300 credit voucher (good
for today only) from Wal-Mart Online. Go to
<www.wal-mart.com> and select $300 worth
of merchandise. Use Add to Cart to keep a
running total, and use Review Cart to print
your final selection. Compare your list with
your classmates’ lists. What explains the dif-
ferences? Would you have purchased your
items if you had received $300 in cash to be
spent whenever and wherever you pleased?
 chapter seven • the theory of consumer choice 173

Appendix to
Chapter 7
Indifference Curve Analysis
A more advanced explanation of consumer behaviour and equilibrium is based on
(1) budget lines and (2) so-called indifference curves.

The Budget Line: What Is Attainable

budget line A budget line (or, more technically, a budget constraint) is a schedule or curve that
A line that shows
shows various combinations of two products a consumer can purchase with a spe-
various combina-
cific money income. If the price of product A is $1.50 and the price of product B is
tions of two prod-
ucts a consumer$1.00, a consumer could purchase all the combinations of A and B shown in Table
A7-1 with $12 of money income. At one extreme, the consumer might spend all the
can purchase with
a specific moneyincome on eight units of A and have nothing left to spend on B. Or, by giving up two
income, given the
units of A and thereby freeing $3, the consumer could have six units of A and three
products’ prices.
of B. At the other extreme, the consumer could buy 12 units of B at $1.00 each,
spending his or her entire money income on B with nothing left to spend on A.
Figure A7-1 shows the same budget line graphically. Note that the graph is not
restricted to whole units of A and B as is the table. Every point on the graph repre-
sents a possible combination of A and B, including fractional quantities. The slope
of the graphed budget line measures the ratio of the price of B to the price of A;
more precisely, the absolute value of the slope is
PB/PA = $1.00/$1.50 = 2/3. This is the mathe-
matical way of saying that the consumer must
TABLE A7-1 THE BUDGET
forgo two units of A (measured on the vertical
LINE: WHOLE-UNIT
axis) to buy three units of B (measured on the
COMBINATIONS
horizontal axis). In moving down the budget
OF A AND B
or price line, two units of A (at $1.50 each) must
ATTAINABLE
be given up to obtain three more units of B (at
WITH AN INCOME
$1.00 each). This yields a slope of 2/3.
OF $12
The budget line has two other significant
Units of A Units of B characteristics:
(price = $1.50) (price = $1.00) Total expenditure
1. Income changes The location of the
8 0 $12 (= $12 + $0) budget line varies with money income.
6 3 $12 (= $9 + $3) An increase in money income shifts the
4 6 $12 (= $6 + $6) budget line to the right; a decrease in
money income shifts it to the left. To verify
2 9 $12 (= $3 + $9)
this, recalculate Table A7-1, assuming that
0 12 $12 (= $0 + $12)
money income is (a) $24 and (b) $6 and
plot the new budget lines in Figure A7-1.
174 Part Two • Microeconomics of Product Markets

FIGURE A7-1 A CONSUMER’S 2. Price changes A change in product

BUDGET LINE prices also shifts the budget line. A decline
in the prices of both products—the equiv-
12 alent of an increase in real income—shifts
the curve to the right. (You can verify this
10 Income = $12 by recalculating Table A7-1 and replotting
PA = $1.50 Figure A7-1 assuming that PA = $.75 and
Quantity of A

8 PB = $.50.) Conversely, an increase in the

(Unattainable) prices of A and B shifts the curve to the
6 left. (Assume PA = $3 and PB = $2 and re-
work Table A7-1 and Figure A7-1 to sub-
4 stantiate this statement.)
Income = $12
(Attainable) PB = $1.00
2 Note what happens if PB changes while PA and
money income remain constant. In particular, if
0 PB drops, say, from $1.00 to $.50, the lower end
2 4 6 8 10 12 of the budget line fans outward to the right.
Quantity of B Conversely, if PB increases, say, from $1.00 to
The budget line shows all the combinations of any two prod- $1.50, the lower end of the line fans inward
ucts that can be purchased given the prices of the products to the left. In both instances the line remains
and the consumer’s money income. anchored at eight units on the vertical axis
because PA has not changed.

Indifference Curves: What Is Preferred

Budget lines reflect objective market data, specifically income and prices. They
reveal combinations of products A and B that can be purchased given current
money income and prices.
indifference Indifference curves, however, reflect subjective information about consumer
curves Curves preferences for A and B. An indifference curve shows all the combinations of two
showing the differ- products A and B that will yield the same total satisfaction or total utility to a con-
ent combinations of
two products that sumer. Table A7-2 and Figure A7-2 present a hypothetical indifference curve for
yield the same products A and B. The consumer’s subjective preferences are such that he or she will
satisfaction or utility realize the same total utility from each combination of A and B shown in the table
to a consumer. or on the curve. The consumer will be indifferent (will not care) as to which combi-
nation is actually obtained.
Indifference curves have several important characteristics.

INDIFFERENCE CURVES ARE DOWNSLOPING

An indifference curve slopes downward because
TABLE A7-2 AN INDIFFERENCE more of one product means less of the other, if
SCHEDULE total utility is to remain unchanged. Suppose the
(WHOLE UNITS) consumer moves from one combination of A and
B to another, say, from j to k in Figure A7-2. In so
Combination Units of A Units of B
doing, the consumer obtains more of product B,
j 12 2 increasing total utility. But because total utility is
k 6 4 the same everywhere on the curve, the consumer
must give up some of the other product, A,
l 4 6
to reduce total utility by a precisely offsetting
m 3 8
amount. Thus more of B necessitates less of A,
and the quantities of A and B are inversely
 chapter seven • the theory of consumer choice 175

FIGURE A7-2 A CONSUMER’S related. A curve that reflects inversely related

INDIFFERENCE variables is downward sloping.
CURVE
INDIFFERENCE CURVES ARE CONVEX
TO THE ORIGIN
j A downward-sloping curve can be concave
12
(bowed outward) or convex (bowed inward) to
10 the origin. A concave curve has an increasing
Quantity of A

(steeper) slope as one moves down the curve,

8 while a convex curve has a diminishing (flatter)
k slope as one moves down the curve. Note in
6
Figure A7-2 that the indifference curve is con-
l vex to the origin. Its slope diminishes or
4
m
becomes flatter as we move from j to k to l, and
2 I so on down the curve. Technically, the slope of
the indifference curve at each point measures
0 2 4 6 8 10 12 the marginal rate of substitution (MRS) of the
Quantity of B combination represented by that point. The
slope or MRS shows the rate at which the con-
Every point on indifference curve I represents some combina- sumer who possesses that combination will
tion of products A and B, and all those combinations are
equally satisfactory to the consumer. That is, each combina- substitute one good for the other (say, B for A)
tion of A and B on the curve yields the same total utility. to remain equally satisfied. The diminishing
slope of the indifference curve means the will-
ingness to substitute B for A diminishes as we
move down the curve.
marginal The rationale for this convexity—that is, for a diminishing MRS—is that con-
rate of sumers’ subjective willingness to substitute B for A (or A for B) will depend on the
substitu- amounts of B and A they have to begin with. Consider Table A7-2 and Figure A7-2
tion (mrs) again, beginning at point j. Here, in relative terms, the consumer has a substantial
The rate at which a
consumer is pre- amount of A and very little of B. Within this combination, a unit of B is very valu-
pared to substitute able (that is, its marginal utility is high), while a unit of A is less valuable (its mar-
one good for ginal utility is low). The consumer will then be willing to give up a substantial
another (from a amount of A to get, say, two more units of B. In this case, the consumer is willing to
given combination
of goods) and
forgo six units of A to get two more units of B; the MRS is 6/2 or 3.
remain equally satis- But at point k the consumer has less A and more B. Here A is somewhat more valu-
fied (have the same able and B less valuable at the margin. In a move from point k to point l, the consumer
total utility); equal to is willing to give up only two units of A to get two more units of B, so the MRS is only
the slope of a con- 2/2 or 1. Having still less of A and more of B at point l, the consumer is willing to give
sumer’s indifference
curve at each point
up only one unit of A in return for two more units of B and the MRS falls to 1/2.
on the curve. Generally, as the amount of B increases, the marginal utility of additional units of
B decreases. Similarly, as the quantity of A decreases, its marginal utility increases. In
Figure A7-2 we see that in moving down the curve, the consumer will be willing to
give up smaller and smaller amounts of A to offset acquiring each additional unit
of B. The result is a curve with a diminishing slope, a curve that is convex to the ori-
gin. The MRS declines as one moves southeast along the indifference curve.

<ingrimayne.saintjoe.edu/
econ/MaximizingBeha/ The Indifference Map
Indifference.html>
Another look at The single indifference curve of Figure A7-2 reflects some constant (but unspecified)
indifference curves level of total utility or satisfaction. It is possible and useful to sketch a whole series
176 Part Two • Microeconomics of Product Markets

FIGURE A7-3 AN INDIFFERENCE of indifference curves or an indifference map,

MAP as shown in Figure A7-3. Each curve reflects a
different level of total utility. Specifically, each
curve to the right of our original curve (labelled
I3 in Figure A7-3) reflects combinations of A and
12 B that yield more utility than I3. Each curve to
the left of I3 reflects less total utility than I3. As
10 we move out from the origin, each successive
indifference curve represents a higher level of
8 utility. To demonstrate this fact, draw a line in a
northeasterly direction from the origin; note
Quantity of A

6 that its points of intersection with successive

curves entail larger amounts of both A and B
and, therefore, higher levels of total utility.
4
I4
2 I3 Equilibrium at Tangency
I2 Since the axes in Figures A7-1 and A7-3 are
I1
identical, we can superimpose a budget line on
0 2 4 6 8 10 12 the consumer’s indifference map, as shown in
Quantity of B Figure A7-4. By definition, the budget line indi-
cates all the combinations of A and B that the
An indifference map is a set of indifference curves. Curves
farther from the origin indicate higher levels of total utility. consumer can attain with his or her money
Thus, any combination of products A and B represented by a income given the prices of A and B. Of these
point on I4 has greater total utility than any combination of A attainable combinations, the consumer will
and B represented by a point on I3, I2, and I1. prefer that combination that yields the greatest
satisfaction or utility. Specifically, the utility-
maximizing combination will be the combina-
indifference tion lying on the highest attainable indifference curve, which is called the
map A series of consumer’s equilibrium position.
indifference curves, In Figure A7-4 the consumer’s equilibrium position is at point X, where the
each of which rep-
resents a different
budget line is tangent to I3. Why not point Y? Because Y is on a lower indifference
level of total utility curve, I 2. By moving down the budget line—by shifting dollars from purchases of
and together show A to purchases of B—the consumer can attain an indifference curve farther from the
the preferences of origin and thereby increase the total utility derived from the same income. Why not
the consumer. point Z? For the same reason as for Y: point Z is on a lower indifference curve, I1.
equilibrium By moving up the budget line—by reallocating dollars from B to A—the consumer
position The can get on the higher indifference curve I3 and increase total utility.
combination of How about point W on indifference curve I4? While it is true that W would yield
products that yields a greater total utility than X, point W is beyond (outside) the budget line and, hence,
the greatest satis- is not attainable by the consumer. Point X represents the optimal attainable combi-
faction or utility.
nation of products A and B. Note that, according to the definition of tangency, the
slope of the highest attainable indifference curve equals the slope of the budget line.
Because the slope of the indifference curve reflects the MRS (marginal rate of sub-
stitution) and the slope of the budget line is PB/PA, the consumer’s optimal or equi-
librium position is the point where
PB
MRS = ᎏ
PA
(You may benefit by trying to answer Appendix Key Question 3 at this time.)
 chapter seven • the theory of consumer choice 177

FIGURE A7-4 THE CONSUMER’S The Measurement of Utility

EQUILIBRIUM There is an important difference between the
POSITION marginal utility theory of consumer demand
and the indifference curve theory. The marginal
12 utility theory assumes that utility is numerically
measurable, that is, that the consumer can say
10
how much extra utility he or she derives from
each extra unit of A or B. The consumer needs
Quantity of A

8
that information to realize the utility-maximiz-
Y ing (equilibrium) position, as indicated by
6
W
Marginal utility of A Marginal utility of B
X ᎏᎏᎏ = ᎏᎏᎏ
4 Price of A Price of B
I4
2 I3 The indifference curve approach imposes a less
I2 stringent requirement on the consumer, who
Z I
0
1 need only specify whether a particular combi-
2 4 6 8 10 12 nation of A and B will yield more, less, or the
Quantity of B same amount of utility than some other combi-
The consumer’s equilibrium position is represented by point X, nation of A and B. The consumer need only say,
where the black budget line is tangent to indifference curve I3. for example, that six units of A and seven of B
The consumer buys four units of A at $1.50 per unit and six of B will yield more (or less) satisfaction than four of
at $1.00 per unit with a $12 money income. Points Z and Y rep- A and nine of B. Indifference curve theory does
resent attainable combinations of A and B that yield less total
utility, as is evidenced by the fact that they are on lower indif- not require that the consumer specify how much
ference curves. Point W would entail more utility than X, but more (or less) satisfaction will be realized.
it requires a greater income than the $12 represented by the When we compare the equilibrium situations
budget line. in the two theories, we find that in the indiffer-
ence curve analysis, the MRS equals PB/PA at
equilibrium; however, in the marginal utility
approach, the ratio of marginal utilities equals
PB/PA. We therefore deduce that at equilibrium, the MRS is equivalent in the mar-
ginal utility approach to the ratio of the marginal utilities of the last purchased units
of the two products.2

The Derivation of the Demand Curve

We noted earlier that with a fixed price for A, an increase in the price of B will
cause the bottom of the budget line to fan inward to the left. We can use that fact
to derive a demand curve for product B. In Figure A7-5(a) we reproduce the part
of Figure A7-4 that shows our initial consumer equilibrium at point X. The budget
line determining this equilibrium position assumes that money income is $12 and
that PA = $1.50 and PB = $1.00. Let’s see what happens to the equilibrium posi-
tion when we increase PB to $1.50 and hold both money income and the price
of A constant.

2
If we begin with the utility-maximizing rule, MUA /PA = MUB /PB, and then multiply through by
PB and divide through by MUA, we obtain PB /PA = MUB /MUA. In indifference curve analysis we
know that at the equilibrium position MRS = PB /PA. Hence, at equilibrium, MRS also equals
MUB /MUA.
178 Part Two • Microeconomics of Product Markets

FIGURE A7-5 DERIVING THE The result is shown in Figure A7-5(a). The
DEMAND CURVE budget line fans to the left, yielding a new equi-
librium point X⬘ where it is tangent to lower
12 indifference curve I2. At X⬘ the consumer buys
three units of B and five of A compared with
four of A and six of B at X. Our interest is in B,
10
and we now have sufficient information to
locate two points on the demand curve for
8
Quantity of A

product B. We know that at equilibrium point

PB = $1.00
X, the price of B is $1.00 and six units are pur-
6 chased; at equilibrium point X⬘, the price of B is
$1.50 and three units are purchased.
X⬘ X These data are shown graphically in Figure
4
A7-5(b) as points on the consumer’s demand
I3 curve for B. Note that the horizontal axes of Fig-
2
ure A7-5(a) and (b) are identical; both measure
PB = $1.50 I2 the quantity demanded of B. We can there-
0 fore drop vertical reference lines from Figure
2 4 6 8 10 12
A7-5(a) down to the horizontal axis of Figure
Quantity of B
A7-5(b). On the vertical axis of Figure A7-5(b)
(a) Two equilibrium positions we locate the two chosen prices of B. Knowing
that these prices yield the relevant quantities
demanded, we locate two points on the
demand curve for B. By simple manipulation of
the price of B in an indifference curve–budget
line context, we have obtained a downward-
sloping demand curve for B. We have thus
again derived the law of demand assuming
Price of B

$1.50 other things are equal, since only the price of B

was changed (the price of A and the consumer’s
1.00 money income and tastes remained constant).
In this case, we have derived the demand curve
.50
without resorting to the questionable assump-
tion that consumers can measure utility in units
DB called utils. In this indifference curve approach,
0 consumers simply compare combinations of
1 2 3 4 5 6 7 8 9 10 11 12
products A and B and determine which combi-
Quantity of B
nation they prefer given their incomes and the
(b) The demand curve for product B prices of the two products.
Panel (a): When the price of product B is increased from $1.00
to $1.50, the equilibrium position moves from X to X⬘, decreas-
ing the quantity of product B demanded from six to three units.
Panel (b): The demand curve for product B is determined by
plotting the $1.00–six-unit and $1.50–three-unit price–
quantity combinations for product B.
 chapter seven • the theory of consumer choice
appendix summary
1. The indifference curve approach to consumer
behaviour is based on the consumer’s budget
line and indifference curves.
2. The budget line shows all combinations of
two products that the consumer can purchase
given product prices and money income.
3. A change in either product prices or money
income moves the budget line.
4. An indifference curve shows all combina-
tions of two products that will yield the same
total utility to a consumer. Indifference curves
are downward sloping and convex from the
origin.
appendix terms and concepts
budget line, p. 173 marginal rate of substitution
indifference curves, p. 174 (MRS), p. 175
appendix study questions
1. What information is embodied in a budget
line? What shifts occur in the budget line
when money income (a) increases and (b) de-
creases? What shifts occur in the budget line
when the price of the product shown on the
vertical axis (a) increases and (b) decreases?
2. What information is contained in an indiffer-
ence curve? Why are such curves (a) down-
ward sloping and (b) convex from the origin?
Why does total utility increase as the consumer
moves to indifference curves farther from the
origin? Why can’t indifference curves intersect?
3. APPENDIX KEY QUESTION Using
Figure A7-4, explain why the point of tan-
gency of the budget line with an indifference
curve is the consumer’s equilibrium position.
Explain why any point where the budget line
intersects an indifference curve is not equilib-
rium. Explain: “The consumer is in equilib-
rium where MRS = PB /PA.”
4. Assume that the data in the accompanying
table give an indifference curve for Mr. Chen.
179
5. An indifference map consists of a number of
indifference curves; the farther from the ori-
gin, the higher the total utility associated with
a curve.
6. The consumer is in equilibrium (utility is max-
imized) at the point on the budget line that
lies on the highest attainable indifference
curve. At that point the budget line and indif-
ference curve are tangent.
7. Changing the price of one product shifts the
budget line and determines a new equilibrium
point. A downsloping demand curve can be
determined by plotting the price–quantity
combinations associated with two or more
equilibrium points.
indifference map, p. 176
equilibrium position, p. 177
Graph this curve, putting A on the vertical
axis and B on the horizontal axis. Assuming
that the prices of A and B are $1.50 and $1.00,
respectively, and that Mr. Chen has $24 to
spend, add his budget line to your graph.
What combination of A and B will Mr. Chen
purchase? Does your answer meet the MRS =
PB /PA rule for equilibrium?
Units of A Units of B
16 6
12 8
8 2
4 24
5. Explain graphically how indifference analysis
can be used to derive a demand curve.
6. Advanced analysis: Demonstrate mathemati-
cally that the equilibrium condition MRS =
PB /PA is the equivalent of the utility-maximiz-
ing rule MUA /PA = MUB /PB.
 EIGHT

The
Organization
and Costs of
Production

O
ur attention now turns from the behav-

iour of consumers to the behaviour of

IN THIS CHAPTER producers. In market economies, a wide

Y OU WILL LEARN: variety of businesses, from family-owned

The various organizational businesses to large corporations, produce an

forms a firm can take.
even wider variety of goods and services.
•
The nature of economic costs. Each business requires resources to produce
•
About a firm’s short-run its products. In obtaining and using resources,
production relationships. a firm makes monetary payments to resource
•
About a firm’s short-run owners (for example, workers) and incurs
production costs.
opportunity costs when using resources it
•
The link between a firm’s size already owns (for example, entrepreneurial
and costs in the long run.
talent). Those payments and opportunity costs

together make up the firm’s costs of produc-

tion, which we discuss in this chapter.

 chapter eight • the organization and the costs of production 181

Then in the next several chapters, we bring product demand, product prices, and
revenue back into the analysis and explain how firms compare revenues and costs
in determining how much to produce. Our ultimate purpose is to show how those
comparisons relate to economic efficiency.

The Business Sector

A firm can be organized several ways. It will be useful to distinguish among a plant,
a firm, and an industry.
plant A physi- ● A plant is a physical establishment—a factory, farm, mine, store, or ware-
cal establishment house—that performs one or more functions in producing, fabricating, and
that performs one distributing goods and services.
or more functions
in producing, ● A firm is a business organization that owns and operates plants. Some firms
fabricating, and operate only one plant, but many own and operate several.
distributing goods
and services. ● An industry is a group of firms that produce the same, or similar, products.
firm An organiza- The organizational structures of firms are often complex and varied. Multiplant firms
tion that employs may be organized horizontally, with several plants performing much the same func-
resources to tion. Examples are the multiple bottling plants of Coca-Cola and the many individ-
produce a good or
service for profit
ual Canadian Tire stores. Firms may be vertically integrated, meaning they own plants
and owns and that perform different functions in the various stages of the production process. For
operates one or example, oil companies such as Petro-Canada own oil fields, refineries, and retail
more plants. gasoline stations. Some firms are conglomerates, so named because they have plants
that produce products in several industries. For example, Power Corp. operates in
industry A such diverse fields as communications, and industrial, financial, and energy services.
group of firms that
produce the same
or similar products. Legal Forms of Businesses
The business population is extremely diverse, ranging from giant corporations such
as Nortel, with sales in 2000 of U.S.$30 billion and more than 94,500 employees
worldwide, to neighbourhood specialty shops and mom-and-pop groceries with
one or two employees and sales of only $200 to $300 per day. There are three major
sole pro- legal forms of businesses.
prietorship
An unincorporated 1. A sole proprietorship is a business owned and operated by one person. Usu-
firm owned and ally, the proprietor (the owner) personally supervises its operation.
operated by one
person. 2. The partnership form of business organization is a natural outgrowth of the
sole proprietorship. In a partnership, two or more individuals (the partners)
partnership agree to own and operate a business together. Usually they pool their financial
An unincorporated
firm owned and resources and business skills. Consequently, they share the risks and the prof-
operated by two or its or losses.
more people.
3. A corporation is a legal creation that can acquire resources, own assets, pro-
corporation duce and sell products, incur debts, extend credit, sue and be sued, and per-
A legal entity char- form the functions of any other type of enterprise. A corporation is distinct and
tered by the federal separate from the individual stockholders who own it. Hired managers run
or provincial gov-
ernments that oper-
most corporations.
ates as a distinct
and separate body Advantages and Disadvantages
from the individuals
who own it. Each form of business enterprise has advantages and disadvantages.
182 Part Two • Microeconomics of Product Markets

SOLE PROPRIETORSHIPS
Sole proprietorships are very numerous because they are easy to setup and organ-
ize; there is virtually no red tape or legal expense. The proprietor is the boss and has
substantial freedom of action. Because the proprietor’s profit income depends on
the enterprise’s success, strong incentive exists to manage the business efficiently.
Sole proprietorships also have several disadvantages. With rare exceptions, the
financial resources of a sole proprietorship are insufficient to permit the firm to grow
into a large enterprise. Finances are usually limited to what the proprietor has in the
bank and can borrow. Since proprietorships often fail, commercial banks are not
eager to extend them credit.
Also, being totally in charge of an enterprise necessitates that the proprietor carry
out all management functions. A proprietor must make decisions on buying and
selling, the hiring and training of personnel, and producing, advertising, and dis-
tributing the firm’s product. In short, the potential benefits of specialization in busi-
ness management are not available to the typical small-scale proprietorship.
Finally, and most important, the proprietor is subject to unlimited liability. Indi-
viduals in business for themselves risk not only the assets of the firm but their per-
sonal assets as well. If the assets of an unsuccessful sole proprietorship are
insufficient to pay the firm’s bills, creditors can file claims against the proprietor’s
personal property.

PARTNERSHIP
Like the sole proprietorship, a partnership is easy to organize. Although the part-
ners usually sign a written agreement, there is not much legal red tape or legal
expense. Also, greater specialization in management is possible, because a partner-
ship has two or more participants, and, because there is more than one owner, the
financial resources of a partnership are likely to be greater than the resources of a
sole proprietorship. Consequently, chartered banks regard partnerships as some-
what better risks than sole proprietorships.
Partnerships have some of the shortcomings of the proprietorship and also some
of their own. Whenever several people participate in management, the divided
authority may lead to inconsistent policies or to inaction when action is required.
Worse, the partners may disagree on basic policy. Although the finances of partner-
ships are generally superior to sole proprietorships, the finances of partnerships are
still severely limited. The combined financial resources of three or four partners may
still not be enough to ensure the growth of a successful enterprise.
The continuity of a partnership is precarious. Generally, when one partner dies or
withdraws, the partnership must be dissolved and reorganized, with inevitable dis-
ruption of its operations. Finally, unlimited liability plagues a partnership, just as it
does a proprietorship. Each partner is liable for all business debts incurred, not only
as a result of their own performance but also as a result of the performance of any other
partner. Wealthy partners risk their wealth on the prudence of less affluent partners.

CORPORATION
The advantages of the corporate form of business enterprise have catapulted it into
a dominant position in Canada. Although corporations are relatively small in num-
ber, many of them are large in size and in scale of operations. The corporation is by
far the most effective form of business organization for raising financial capital
(money). The corporation employs unique methods of finance—the selling of stocks
and bonds—that enable it to pool the financial resources of large numbers of people.
 chapter eight • the organization and the costs of production 183

stocks Owner- Stocks are shares of ownership of a corporation, whereas bonds are promises to repay
ship shares in a cor- a loan, usually at a set rate of interest (see “The Last Word” at the end of this chapter).
poration. Financing via sales of stocks and bonds also provides advantages to those who
bonds Financial purchase these securities. Such financing makes it possible for a household to own a
devices through part of the business and to share the expected monetary rewards without actively
which a borrower (a managing the firm. An individual investor can spread risks by buying the securities
firm or government) of several corporations, and it is usually easy for holders of corporate securities to
is obligated to pay sell their holdings. Organized stock exchanges simplify the transfer of securities
the principle and
interest on a loan at
from sellers to buyers. This ease of sale increases the willingness of savers to make
a specific date in financial investments in corporate securities. Corporations have easier access to
the future. bank credit than other types of business organizations do, and since corporations
are better risks, they are more likely to become profitable clients of banks.
limited Corporations have the distinct advantage of limited liability. The owners (stock-
liability holders) of a corporation risk only what they paid for their stock. Their personal assets
Restriction of the are not at stake if the corporation defaults on its debts. Creditors can sue the corpo-
maximum loss to
a predetermined
ration as a legal entity but cannot sue the owners of the corporation as individuals.
amount for the own- Because of their ability to attract financial capital, successful corporations can eas-
ers (stockholders) ily expand the scope of their operations and realize the benefits of expansion. For
of a corporation; example, they can take advantage of mass-production technologies and division of
the maximum loss labour. A corporation can hire specialists in production, accounting, and marketing
is the amount they
paid for their shares
functions, and thus improve efficiency.
of stock. As a legal entity, the corporation has a life independent of its owners and its offi-
cers. Legally, at least, corporations are immortal. The transfer of corporate owner-
ship through inheritance or the sale of stock does not disrupt the continuity of the
corporation. Corporations have permanence that is conducive to long-range plan-
ning and growth.
The corporation’s advantages are of tremendous significance and typically over-
ride any associated disadvantages, yet the corporate form has certain drawbacks.
Some red tape and legal expense are involved in obtaining a corporate charter. From
the social point of view, the corporate form of enterprise lends itself to certain
abuses; because the corporation is a legal entity, unscrupulous business owners can
sometimes avoid personal responsibility for questionable business activities by
double adopting the corporate form of enterprise.
taxation A disadvantage to the owners of corporations is the double taxation of some cor-
The taxation of both porate income. Corporate profit that is shared among stockholders as dividends is
corporate net taxed twice—once as corporate profit and again as stockholders’ personal income.
income (profits) and
the dividends paid
from this net income The Principal–Agent Problem
when they become
the personal income Many Canadian corporations are extremely large and that size creates a potential
of households. problem. In sole proprietorships and partnerships, the owners of the real and finan-
cial assets of the firm enjoy direct control of those assets, but ownership of large cor-
principal– porations is spread over tens or hundreds of thousands of stockholders. The owners
agent of a corporation usually do not manage it, they instead hire others to do so.
problem A
conflict of interest That practice can create a principal–agent problem. The principals are the stock-
that occurs when holders who own the corporation and who hire executives as their agents to run the
agents (workers or business on their behalf. The interests of these managers (the agents) and the wishes
managers) pursue of the owners (the principals) do not always coincide. The owners typically want
their own objectives
to the detriment
maximum company profit and stock price. The agents, however, may want the
of the principal’s power, prestige, and pay that usually accompany control over a large enterprise,
(stockholders) goals. independent of its profitability and stock price.
184 Part Two • Microeconomics of Product Markets

So, a conflict of interest may develop. For example, executives may build expen-
sive office buildings, enjoy excessive perks such as corporate jets, and pay too much
to acquire other corporations. Consequently, the firm will have bloated costs, and
profits and stock prices will not be maximized for the owners.
Many corporations have addressed the principal–agent problem by providing a
substantial part of executive pay as shares of the companies’ stock. The idea is to
align the interest of the executives more closely with those of the broader corporate
owners. By pursuing high profits and share prices—which benefit the broader own-
ers—the executives enhance their own income. (Key Question 2)

● A plant is a physical establishment that con-
tributes to the production of goods and serv-
ices; a firm is a business organization that owns
and operates plants; plants may be arranged
horizontally, be vertically integrated, or take on
a conglomerate form.
● The three basic legal forms of business are the
sole proprietorship, the partnership, and the
corporation. While sole proprietorships make
up nearly three-fourths of all firms, corpora-
tions account for about nine-tenths of total
sales.
● The major advantages of corporations are their
ability to raise financial capital, the limited liabil-
ity they bestow on owners, and their continuing
life beyond the life of their owners and managers.
● The principal–agent problem is the conflict of
interest that can occur when agents (execu-
tives) pursue their own objectives to the detri-
ment of the principals’ (stockholders’) goals.

Economic Costs
Costs exist because resources are scarce and have alternative uses. When society
Opportunity
Cost uses a combination of resources to produce a particular product, it forgoes all alter-
native opportunities to use those resources for any other purpose. The measure of
the economic cost or opportunity cost of any resource used to produce a good is the
value or worth it would have in its best alternative use.
economic We stressed this point in our analysis of production possibilities in Chapter 2,
(opportu- where we found that the opportunity cost of producing more pizzas is the industrial
nity) cost robots that must be forgone. Similarly, the opportunity cost of the steel used in con-
A payment that
must be made to
structing office buildings is the value it would have in manufacturing automobiles
obtain and retain or refrigerators. The paper used for printing economics textbooks is not available for
the services of a printing encyclopedias or romance novels. And if an assembly line worker is capa-
resource; the ble of assembling either personal computers or washing machines, then the cost to
income a firm society of employing that worker in a computer plant is the contribution that
must provide to a
resource supplier to
worker would otherwise have made in producing washing machines.
attract the resource
away from an alter- Explicit and Implicit Costs
native use; equal
to the quantity of Now let’s consider costs from the firm’s viewpoint. Keeping opportunity costs in
other products that mind, we can say that economic costs are the payments a firm must make, or the incomes
cannot be produced it must provide, to attract the resources it needs away from alternative production opportu-
when resources are
instead used to
nities. Those payments to resource suppliers are explicit (revealed and expressed) or
make a particular implicit (present but not obvious). So, in producing products firms incur explicit
product. costs and implicit costs:
 chapter eight • the organization and the costs of production 185

explicit ● A firm’s explicit costs are the monetary payments (or cash expenditures) it
costs The makes to those who supply labour services, materials, fuel, transportation
monetary payments services, and the like. Such money payments are for the use of resources
a firm must make to
an outsider to
owned by others.
obtain a resource. ● A firm’s implicit costs are the opportunity costs of using its self-owned, self-
implicit employed resources. To the firm, implicit costs are the money payments that
costs The self-employed resources could have earned in their best alternative use.
monetary income a
firm sacrifices when
For example, suppose you are earning $22,000 a year as a sales representative for
it uses a resource it a T-shirt manufacturer. At some point you decide to open a retail store of your own
owns rather than to sell T-shirts. You invest $20,000 of savings that has been earning you $1000 per
supplying the year. You decide that your new firm will occupy a small store that you own and have
resource in the been renting out for $5000 per year. You hire one clerk to help you in the store, pay-
market; equal to
what the resource
ing her $18,000.
could have earned A year after you open the store, you total up your accounts and find the following:
in the best-paying
alternative
employment Total sales revenue . . . . . . . . . . . . . . . . . .$120,000
(includes a normal
Cost of T-shirts . . . . . . . . .$40,000
profit).
Clerk’s salary . . . . . . . . . . 18,000
Utilities . . . . . . . . . . . . . . . 5,000
Total (explicit) costs . . . . . . . . . . . . . . . . . 63,000
Accounting profit . . . . . . . . . . . . . . . . . . . 57,000

Looks good. But unfortunately your accounting profit of $57,000 ignores your
implicit costs and thus overstates the economic success of your venture. By provid-
ing your own financial capital, building, and labour, you incur implicit costs (for-
gone incomes) of $1000 of interest, $5000 of rent, and $22,000 of wages. And, if your
entrepreneurial talent is worth, say, $5000 annually in other business endeavours of
similar scope, you have also ignored that implicit cost. So:

Accounting profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$57,000

Forgone interest . . . . . . . . . . . . . . . . .$ 1,000
Forgone rent . . . . . . . . . . . . . . . . . . . . 5,000
Forgone wages . . . . . . . . . . . . . . . . . . 22,000
Forgone entrepreneurial income . . . . 5,000
Total implicit costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33,000
normal Economic profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000
profit Payment
that must be made
by a firm to obtain
and retain entrepre- Normal Profit as a Cost
neurial ability; the
minimum payment The $5000 implicit cost of your entrepreneurial talent in the above example is a nor-
entrepreneurial abil- mal profit. As is true of the forgone rent and forgone wages, the payment you could
ity must receive to otherwise receive for performing entrepreneurial functions is indeed an implicit
induce it to perform
the entrepreneurial
cost. If you did not realize at least this minimum, or normal, payment for your
functions for a firm; effort, you could withdraw from this line of business and shift to a more attractive
an implicit cost. endeavour. So a normal profit is a cost of doing business.
186 Part Two • Microeconomics of Product Markets

The economist includes as costs of production all the costs—explicit and implicit,
including a normal profit—required to attract and retain resources in a specific line of
production. For economists, a firm’s economic costs are the opportunity costs of the
resources used, whether those resources are owned by others or by the firm. In
our example, economic costs are $96,000 (= $63,000 of explicit costs + $33,000 of
implicit costs).

Economic Profit (or Pure Profit)

Obviously, then, economists use the term profit differently from the way account-
ants use it. To the accountant, profit is the firm’s total revenue less its explicit costs
economic (or accounting costs). To the economist, economic profit is total revenue less eco-
profit The total nomic costs (explicit and implicit costs, the latter including a normal profit to the
revenue of a firm entrepreneur). So, when an economist says a certain firm is earning only enough
less its economic
costs (which
revenue to cover its costs, this means it is meeting all explicit and implicit costs and
includes both the entrepreneur is receiving a payment just large enough to retain his or her talents
explicit costs and in the present line of production.
implicit costs); also If a firm’s total revenue exceeds all its economic costs (explicit + implicit), any
called pure profit residual goes to the entrepreneur. That residual is called an economic, or pure, profit.
and above normal
profit.
In short:
Economic profit = total revenue – economic cost
In our example, economic profit is $24,000, found by subtracting the $96,000 of eco-
nomic cost from the $120,000 of revenue. An economic profit is not a cost, because it
is a return in excess of the normal profit that is required to retain the entrepreneur
in this particular line of production. Even if the economic profit is zero, the entre-
preneur is still covering all explicit and implicit costs, including a normal profit. In
our example, as long as accounting profit is $33,000 or more (so that economic profit
is zero or more), you will be earning a $5000 normal profit and will, therefore, con-
tinue to operate your T-shirt store.
Figure 8-1 shows the relationship among the various cost and profit concepts that
we have just discussed. To test yourself, you might want to enter cost data from our
example in the appropriate blocks. (Key Question 4)

FIGURE 8-1 ECONOMIC PROFIT VERSUS ACCOUNTING PROFIT

Economic profit is equal
to total revenue less Economic
economic costs. Eco- profit
Economic (opportunity)

Accounting
nomic costs are the sum
Total revenue

Implicit costs profit

of explicit and implicit (including a
costs and include a nor- normal profit)
mal profit to the entre-
costs

preneur. Accounting
profit is equal to total Accounting
Explicit costs (explicit
revenue less accounting costs costs only)
(explicit) costs.
 chapter eight • the organization and the costs of production 187

Short Run and Long Run

When the demand for a firm’s product changes, the firm’s profitability may depend
on how quickly it can adjust the amounts of the various resources it employs. It can
easily and quickly adjust the quantities employed of many resources such as hourly
labour, raw materials, fuel, and power. It needs much more time, however, to adjust
its plant capacity—the size of the factory building, the amount of machinery and
equipment, and other capital resources. In some heavy industries such as aircraft
<www.vanderbilt.edu/
manufacturing a firm may need several years to alter plant capacity. Because of
owen/froeb/mgt722/
topics/cost/cost.html> these differences in adjustment time, economists find it useful to distinguish
Cost and production: between two conceptual periods: the short run and the long run. We will discover
short run and long run that costs differ in these two periods.

SHORT RUN: FIXED PLANT

short run A The short run is a period too brief for a firm to alter its plant capacity yet long
period of time in enough to permit a change in the degree to which the fixed plant is used. The firm’s
which producers plant capacity is fixed in the short run. However, the firm can vary its output by
are able to change
the quantities of applying larger or smaller amounts of labour, materials, and other resources to that
some but not all of plant. It can use its existing plant capacity more or less intensively in the short run.
the resources they
employ. LONG RUN: VARIABLE PLANT
long run A For an existing firm, the long run is a period long enough for it to adjust the quan-
period of time long tities of all the resources that it employs, including plant capacity. For the industry,
enough to enable the long run also includes enough time for existing firms to dissolve and leave the
producers of a industry or for new firms to be created and enter the industry. While the short run
product to change is a “fixed-plant” period, the long run is a “variable-plant” period.
the quantities of all
the resources they
employ. ILLUSTRATIONS
If Bombardier hires 100 extra workers for one of its Ski-doo plants or adds an entire
shift of workers, we are speaking of the short run. If it adds a new production facil-
ity and installs more equipment, we are referring to the long run. The first situation
is a short-run adjustment; the second is a long-run adjustment.
The short run and the long run are conceptual periods rather than calendar peri-
ods. In light-manufacturing industries, changes in plant capacity may be accom-
plished almost overnight. A small T-shirt manufacturer can increase its plant capacity
in a matter of days by ordering and installing two or three new cutting tables and
several extra sewing machines. But for heavy industry the long run is a different mat-
ter. Petro-Canada may require several years to construct a new oil refinery.

● Explicit costs are money payments a firm makes
to outside suppliers of resources; implicit costs
are the opportunity costs associated with a
firm’s use of resources its owns.
● Normal profit is the implicit cost of entrepre-
neurship. Economic profit is total revenue less
all explicit and implicit costs, including normal
profit.
● In the short run, a firm’s plant capacity is fixed;
in the long run, a firm can vary its plant size and
firms can enter or leave the industry.
188 Part Two • Microeconomics of Product Markets

Short-Run Production Relationships

A firm’s costs of producing a specific output depend on the prices of the needed
resources and the quantities of resources (inputs) needed to produce that output.
Resource supply and demand determine resource prices. The technological aspects
of production, specifically the relationships between inputs and output, determine
the quantities of resources needed. Our focus will be on the labour-output relation-
ship, given a fixed-plant capacity. But before examining that relationship, we need
to define three terms:
total 1. Total product (TP) is the total quantity, or total output, of a particular good
product (tp) produced.
The total output of a
particular good or 2. Marginal product (MP) is the extra output or added product associated with
service produced by adding a unit of variable resource, in this case labour, to the production
a firm (or a group of process. Thus,
firms or the entire
economy). change in total product
Marginal product = ᎏᎏᎏ
change in labour input
marginal
product 3. Average product (AP), also called labour productivity, is output per unit of
(mp) The extra labour input:
output or added
product associated total product
Average product = ᎏᎏ
with adding a unit units of labour
of a variable
resource to the In the short run, a firm can for a time increase its output by adding units of labour
production process. to its fixed plant. But by how much will output rise when a firm adds the labour?
Why do we say “for a time”?
average
product (ap)
The total output Law of Diminishing Returns
produced per unit The answers are provided in general terms by the law of diminishing returns, also
of a resource
employed (total
called the law of diminishing marginal product. This law assumes that technology is
product divided by fixed, so that the techniques of production do not change. It states that as successive
the quantity of that units of a variable resource (say, labour) are added to a fixed resource (say, capital or land),
employed beyond some point the extra, or marginal, product that can be attributed to each additional
resource). unit of the variable resource will decline. For example, if additional workers are hired
law of to work with a constant amount of capital equipment, output will eventually rise by
diminishing smaller and smaller amounts as more workers are hired.
returns As
successive incre- RATIONALE
ments of a variable
resource are added
Suppose a farmer has a fixed resource of 80 hectares planted in corn. If the farmer
to a fixed resources, does not cultivate the cornfields (clear the weeds) at all, the yield will be 40 bushels
the marginal prod- per hectare. If he cultivates the land once, output may rise to 50 bushels per hectare.
uct of the variable A second cultivation may increase output to 57 bushels per hectare, a third to 61,
resource will even- and a fourth to 63. Succeeding cultivations would add less and less to the land’s
tually decrease.
yield. If this were not so, the world’s need for corn could be fulfilled by extremely
intense cultivation of this single 80-hectare plot of land. Indeed, if diminishing
returns did not occur, the world could be fed out of a flowerpot. Why not? Just keep
adding more seed, fertilizer, and harvesters!
The law of diminishing returns also holds true in nonagricultural industries.
Choosing Assume a wood shop is manufacturing furniture frames. It has a specific amount of
a Little More equipment such as lathes, planers, saws, and sanders. If this shop hired just one or
or Less
two workers, total output and productivity (output per worker) would be very low.
 chapter eight • the organization and the costs of production 189

The workers would have to perform many different jobs, and the advantages of spe-
cialization would not be realized. Time would be lost switching from one job to
another, and machines would stand idle much of the time. In short, the plant would
be understaffed, and production would be inefficient because there would be too
much capital relative to the amount of labour.
<www.kanga.nu/ The shop could eliminate those difficulties by hiring more workers. Then the
~claw/docs/extess/> equipment would be more fully used, and workers could specialize in doing a sin-
Find out whether free gle job. Time would no longer be lost switching from job to job. As more workers
software production
in a bazaar obeys the
were added, production would become more efficient and the marginal product of
law of diminishing each succeeding worker would rise.
returns But the rise could not go on indefinitely. If still more workers were added, beyond
a certain point, overcrowding would set in. Since workers would then have to wait
in line to use the machinery, it would be underused. Total output would increase at
a diminishing rate, because, given the fixed size of the plant, each worker would
have less capital equipment to work with as more and more labour was hired. The
marginal product of additional workers would decline because there would be more
labour in proportion to the fixed amount of capital. Eventually, adding still more
workers would cause so much congestion that marginal product would become neg-
ative and total product would decline. At the extreme, the addition of more and more
labour would exhaust all the standing room, and total product would fall to zero.
Note that the law of diminishing returns assumes that all units of labour are of equal
quality. Each successive worker is presumed to have the same innate ability, motor
coordination, education, training, and work experience. Marginal product ultimately
diminishes, not because successive workers are qualitatively inferior but because
more workers are being used relative to the amount of plant and equipment available.

TABULAR EXAMPLE
Table 8-1 is a numerical illustration of the law of diminishing returns. Column 2
shows the total product, or total output, resulting from combining each level of a
variable input (labour) in column 1 with a fixed amount of capital.

TABLE 8-1 TOTAL, MARGINAL, AND AVERAGE PRODUCT:

THE LAW OF DIMINISHING RETURNS
(1) (2) (3) (4)
Units of the variable Total product (TP) Marginal product (MP), Average product (AP),
resource (labour) change in (2)/change in (1) (2)/(1)

0 0 —
10
1
2
10
25
15
20
冧 Increasing
marginal returns
10.00
12.50

冧
3 45 15.00
15 Diminishing
4 60 marginal returns 15.00
10
5 70 14.00
5

冧
6 75 Negative 12.50
0 marginal returns
7 75 10.71
–5
8 70 8.75
190 Part Two • Microeconomics of Product Markets

Column 3 shows the marginal product (MP), the change in total product associ-
ated with each additional unit of labour. Note that with no labour input, total prod-
uct is zero; a plant with no workers will produce no output. The first three units of
labour reflect increasing marginal returns, with marginal products of 10, 15, and 20
units, respectively. But beginning with the fourth unit of labour, marginal product
diminishes continually, becoming zero with the seventh unit of labour and negative
with the eighth.
Average product, or output per labour unit, is shown in column 4. It is calculated
by dividing total product (column 2) by the number of labour units needed to pro-
duce it (column 1). At five units of labour, for example, AP is 14 (= 70/5).

GRAPHICAL PORTRAYAL
Figure 8-2 (Key Graph) shows the diminishing returns data in Table 8-1 graphically
and further clarifies the relationships between total, marginal, and average prod-
ucts. (Marginal product in Figure 8-2(b) is plotted halfway between the units of
labour, since it applies to the addition of each labour unit.)
Note first in Figure 8-2(a) that total product, TP, goes through three phases: it rises
initially at an increasing rate; then it increases, but at a diminishing rate; finally, after
reaching a maximum, it declines.
Geometrically, marginal product—shown by the MP curve in Figure 8-2(b)—is
the slope of the total product curve. Marginal product measures the change in total
product associated with each succeeding unit of labour. Thus, the three phases of
total product are also reflected in marginal product. Where total product is increas-
ing at an increasing rate, marginal product is rising. Here, extra units of labour are
adding larger and larger amounts to total product. Similarly, where total product is
increasing but at a decreasing rate, marginal product is positive but falling. Each
additional unit of labour adds less to total product than did the previous unit. When
total product is at a maximum, marginal product is zero. When total product
declines, marginal product becomes negative.
Average product, AP in Figure 8-2(b), displays the same tendencies as marginal
product. It increases, reaches a maximum, and then decreases as more units of
labour are added to the fixed plant. Note the relationship between marginal prod-
uct and average product: Where marginal product exceeds average product, aver-
age product rises, and where marginal product is less than average product, average
product declines. It follows that marginal product intersects average product where
average product is at a maximum.
This relationship is a mathematical necessity. If you add a larger number to a total
than the current average of that total, the average must rise; if you add a smaller
number to a total than the current average of that total, the average must fall. You
raise your average examination grade only when your score on an additional (mar-
ginal) examination is greater than the average of all your past scores. You lower
your average when your grade on an additional exam is below your current aver-
age. In our production example, when the amount an extra worker adds to total
product exceeds the average product of all workers currently employed, average
product will rise. Conversely, when an extra worker adds to total product an
amount that is less than the current average product, then average product will
decrease.
The law of diminishing returns is embodied in the shapes of all three curves. But,
as our definition of the law of diminishing returns indicates, economists are most
concerned with its effects on marginal product. The regions of increasing, dimin-
ishing, and negative marginal product (returns) are shown in Figure 8-2(b). (Key
Question 6)
 chapter eight • the organization and the costs of production 191

Key Graph FIGURE 8-2 THE LAW OF DIMINISHING RETURNS

75
Panel (a): As a variable resource TP
(labour) is added to fixed amounts of

Total product, TP
other resources (land or capital), the
total product that results will eventu- 50
ally increase by diminishing amounts,
reach a maximum, and then decline.
Panel (b): Marginal product is the
change in total product associated 25
with each new unit of labour. Average
product is simply output per labour
unit. Note that marginal product
intersects average product at the 0 1 2 3 4 5 6 7 8 9
maximum average product. Quantity of labour
(a) Total product

Increasing Diminishing marginal Negative

Marginal product, MP marginal returns marginal
20 returns returns

10 AP

MP
0 1 2 3 4 5 6 7 8 9
Quantity of labour
(b) Marginal and average product

Quick Quiz
1. Which of the following is an assumption underlying these figures?
a. Firms first hire highly skilled workers and then hire less skilled workers.
b. Capital and labour are both variable, but labour increases more rapidly than capital.
c. Consumers will buy all the output (total product) produced.
d. Workers are of equal quality.
2. Marginal product is
a. the change in total product divided by the change in the quantity of labour.
b. total product divided by the quantity of labour.
c. always positive.
d. unrelated to total product.
3. Marginal product in graph (b) is zero when
a. average product in graph (b) stops rising.
b. the slope of the marginal-product curve in graph (b) is zero.
c. total product in graph (a) begins to rise at a diminishing rate.
d. the slope of the total-product curve in graph (a) is zero.
4. Average product in graph (b)
a. rises when it is less than marginal product.
b. is the change in total product divided by the change in the quantity of labour.
c. can never exceed marginal product.
d. falls whenever total product in graph (a) rises at a diminishing rate.
Answers
1. d; 2. a; 3. d; 4. a
192 Part Two • Microeconomics of Product Markets

Short-Run Production Costs

Production information such as that provided in Table 8-1 and Figure 8-2(a) and (b)
must be coupled with resource prices to determine the total and per-unit costs of
producing various levels of output. We know that in the short run some resources,
those associated with the firm’s plant, are fixed. Others resource, however, are vari-
able. So short-run costs are either fixed or variable.

Fixed, Variable, and Total Cost

Let’s see what distinguishes fixed costs, variable costs, and total costs from one
another.

FIXED COSTS
fixed costs Fixed costs are those costs that in total do not vary with changes in output. Fixed costs
Costs that in total are associated with the very existence of a firm’s plant and, therefore, must be paid
do not change when even if its output is zero. Such costs as rental payments, interest on a firm’s debts, a
the firm changes its
output; the costs of
portion of depreciation on equipment and buildings, and insurance premiums are
fixed resources. generally fixed costs; they do not increase even if a firm produces more. In column
2 in Table 8-2 we assume that the firm’s total fixed cost is $100. By definition, this
fixed cost is incurred at all levels of output, including zero. The firm cannot avoid
paying these costs in the short run.

VARIABLE COSTS
variable Variable costs are those costs that change with the level of output. They include pay-
costs Costs ments for materials, fuel, power, transportation services, most labour, and similar
that in total increase variable resources. In column 3 of Table 8-2 we find that the total of variable costs
when the firm
increases its output
changes directly with output, but note that the increases in variable cost associated
and decrease with succeeding one-unit increases in output are not equal. As production begins,
when it reduces variable cost will for a time increase by a decreasing amount; this is true through the
its output. fourth unit of output in Table 8-2. Beyond the fourth unit, however, variable cost
rises by increasing amounts for succeeding units of output.
The reason lies in the shape of the marginal product curve. At first, as in Figure
8-2(b), marginal product is increasing, so smaller and smaller increases in the
amounts of variable resources are needed to produce successive units of output.
Hence the variable cost of successive units of output decreases. But when, as dimin-
ishing returns are encountered, marginal product begins to decline, larger and
larger additional amounts of variable resources are needed to produce successive
units of output. Total variable cost, therefore, increases by increasing amounts.

TOTAL COST
total cost Total cost is the sum of fixed cost and variable cost at each level of output. It is shown in
The sum of fixed column 4 in Table 8-2. At zero units of output, total cost is equal to the firm’s fixed
cost and variable cost. Then for each unit of the 10 units of production, total cost increases by the same
cost.
amount as variable cost.
Figure 8-3 shows graphically the fixed-cost, variable-cost, and total-cost data
given in Table 8-2. Observe that total variable cost, TVC, is measured vertically from
the horizontal axis at each level of output. The amount of fixed cost, shown as TFC,
is added vertically to the total variable cost curve to obtain the points on the total-
cost curve, TC.
 chapter eight • the organization and the costs of production 193

TABLE 8-2 TOTAL-COST, AVERAGE-COST, AND MARGINAL-COST

SCHEDULES FOR AN INDIVIDUAL FIRM IN THE
SHORT RUN
TOTAL-COST DATA AVERAGE-COST DATA MARGINAL COST
(1) (2) (3) (4) (5) (6) (7) (8)
Total Total Total Total Average Average Average Marginal
product fixed variable cost (TC) fixed cost variable total cost cost (MC)
(Q) cost (TFC) cost (TVC) (AFC) cost (AVC) (ATC)

TC = TFC TFC TVC TC change in TC

AFC = ᎏ AVC = ᎏ ATC = ᎏ MC = ᎏᎏ
+ TVC Q Q Q change in Q

0 $100 $ 0 $ 100
$ 90
1 100 90 190 $100.00 $90.00 $190.00
80
2 100 170 270 50.00 85.00 135.00
70
3 100 240 340 33.33 80.00 113.33
60
4 100 300 400 25.00 75.00 100.00
70
5 100 370 470 20.00 74.00 94.00
80
6 100 450 550 16.67 75.00 91.67
90
7 100 540 640 14.29 77.14 91.43
110
8 100 650 750 12.50 81.25 93.75
130
9 100 780 880 11.11 86.67 97.78
150
10 100 930 1030 10.00 93.00 103.00

FIGURE 8-3 TOTAL COST IS THE SUM OF FIXED COST AND

VARIABLE COST
Total variable cost
(TVC) changes with $1,100 TC
output. Total fixed
cost (TFC) is inde- 1,000
pendent of the level 900
of output. The total TVC
cost (TC) at any out- 800
put is the vertical 700
sum of the fixed cost
Costs

and variable cost at 600

Fixed cost
that output.
500
400
300 Total
cost Variable cost
200
100
TFC
0 1 2 3 4 5 6 7 8 9 10 Q
194 Part Two • Microeconomics of Product Markets

The distinction between fixed and variable costs is significant to the business
manager. Variable costs can be controlled or altered in the short run by changing
production levels. Fixed costs are beyond the business manager’s current control;
they are incurred in the short run and must be paid regardless of output level.

Per-Unit, or Average, Costs

Producers are certainly interested in their total costs, but they are equally concerned
with per-unit, or average, costs. In particular, average-cost data are more meaning-
ful for making comparisons with product price, which is always stated on a per-unit
basis. Average fixed cost, average variable cost, and average total cost are shown in
columns 5 to 7, Table 8-2.

AFC
average Average fixed cost (AFC) for any output level is found by dividing total fixed cost
fixed cost (TFC) by that output (Q). That is,
(afc) A firm’s
total fixed cost TFC
divided by output
AFC = ᎏ
Q
(the quantity of
product produced). Because the total fixed cost is, by definition, the same regardless of output, AFC
must decline as output increases. As output rises, the total fixed cost is spread over
a larger and larger output. When output is just one unit in Table 8-2, TFC and AFC
are the same at $100. But at two units of output, the total fixed cost of $100 becomes
$50 of AFC or fixed cost per unit; then it becomes $33.33 per unit as $100 is spread
over three units, and $25 per unit when spread over four units. This process is some-
times referred to as “spreading the overhead.” Figure 8-4 shows that AFC graphs as
a continuously declining curve as total output is increased.

average AVC
variable Average variable cost (AVC) for any output level is calculated by dividing total
cost (avc) A
firm’s total variable variable cost (TVC) by that output (Q):
cost divided by out-
TVC
put (the quantity of AVC = ᎏ
product produced). Q

FIGURE 8-4 THE AVERAGE-COST CURVES

AFC falls as a given $200
amount of fixed
costs is apportioned
over a larger and
150
larger output. AVC
initially falls because
of increasing mar-
Costs

AFC ATC
ginal returns but then 100 AVC
rises because of
diminishing marginal
returns. Average total 50
cost (ATC) is the ver- AVC
tical sum of average
variable cost (AVC) AFC
and average fixed 0 1 2 3 4 5 6 7 8 9 10 Q
cost (AFC).
 chapter eight • the organization and the costs of production 195

As added variable resources increase output, AVC declines initially, reaches a

minimum, and then increases again. A graph of AVC is a U-shaped or saucer-shaped
curve, as shown in Figure 8-4.
Because total variable cost reflects the law of diminishing returns, so must AVC,
which is derived from total variable cost. Because marginal returns increase initially,
it takes fewer and fewer additional variable resources to produce each of the first
four units of output. As a result, variable cost per unit declines. AVC hits a minimum
with the fifth unit of output, and beyond that point AVC rises as diminishing
returns require more variable resources to produce each additional unit of output.
In simpler terms, at very low levels of output, production is relatively inefficient
and costly. Because the firm’s fixed plant is understaffed, average variable cost is rel-
atively high. As output expands, however, greater specialization and better use of
the firm’s capital equipment yield more efficiency, and variable cost per unit of out-
put declines. As still more variable resources are added, a point is reached when
diminishing returns are incurred. The firm’s capital equipment is now staffed more
intensively, and, therefore, each added input unit does not increase output by as
much as preceding inputs, which means that AVC eventually increases.
You can verify the U or saucer shape of the AVC curve by returning to Table 8-1.
Assume the price of labour is $10 per unit. By dividing average product (output per
labour unit) into $10 (price per labour unit), we determine the labour cost per unit
of output. Because we have assumed labour to be the only variable input, the labour
cost per unit of output is the variable cost per unit of output or AVC. When average
product is initially low, AVC is high. As workers are added, average product rises
average and AVC falls. When average product is at its maximum, AVC is at its minimum.
total cost Then, as still more workers are added and average product declines, AVC rises. The
(atc) A firm’s
total cost divided hump of the average-product curve is reflected in the saucer or U shape of the AVC
by output (the quan- curve. As you will soon see, the two are mirror images.
tity of product pro-
duced); equal to ATC
average fixed cost
plus average vari- Average total cost (ATC) for any output level is found by dividing total cost (TC)
able cost. by that output (Q) or by adding AFC and AVC at that output:
TC TFC TVC
ATC = ᎏ = ᎏ + ᎏ = AFC + AVC
Q Q Q
Choosing Graphically, ATC can be found by adding vertically the AFC and AVC curves, as in
a Little More Figure 8-4. Thus, the vertical distance between the ATC and AVC curves measures
or Less
AFC at any level of output.

Marginal Cost
marginal One final and very crucial cost concept remains: Marginal cost (MC) is the extra, or
cost (mc) The additional, cost of producing one more unit of output. MC can be determined for each
extra or additional added unit of output by noting the change in total cost that that unit’s production
cost of producing
one more unit of
entails:
output equal to the change in TC
change in total cost MC = ᎏᎏ
divided by the change in Q
change in output
(and in the short CALCULATIONS
run to the change in
In column 4, Table 8-2 on page 193, production of the first unit of output increases
total variable cost
divided by the total cost from $100 to $190. Therefore, the additional, or marginal, cost of that first
change in output). unit is $90 (column 8). The marginal cost of the second unit is $80 (= $270 – $190);
196 Part Two • Microeconomics of Product Markets

the MC of the third is $70 (= $340 – $270); and so forth. The MC for each of the 10
units of output is shown in column 8.
MC can also be calculated from the total-variable-cost column, because the only
difference between total cost and total variable cost is the constant amount of fixed
costs ($100). Thus, the change in total cost and the change in total variable cost asso-
ciated with each additional unit of output are always the same.

MARGINAL DECISIONS
Marginal costs are costs the firm can control directly and immediately. Specifically,
MC designates all the additional cost incurred in producing the last unit of output.
Thus, it also designates the cost that can be saved by not producing that last unit.
Average-cost figures do not provide this information. For example, suppose the firm
is undecided whether to produce three or four units of output. At four units Table 8-2
indicates that ATC is $100. But the firm does not increase its total costs by $100 by
producing the fourth unit, nor does it save $100 by not producing that unit. Rather,
the change in costs involved here is only $60, as the MC column in Table 8-2 reveals.
A firm’s decisions as to what output level to produce are typically marginal deci-
sions, that is, decisions to produce a few more or a few less units. Marginal cost is
the change in costs when one more or one fewer unit of output is produced. When
coupled with marginal revenue (which, as you will see in Chapter 9, indicates the
change in revenue from one more or one fewer unit of output), marginal cost allows
a firm to determine whether it is profitable to expand or contract its production. The
analysis in the next three chapters focuses on those marginal calculations.

GRAPHICAL PORTRAYAL
Marginal cost is shown graphically in Figure 8-5 (Key Graph). Marginal cost at first
declines sharply, reaches a minimum, and then rises rather abruptly. This pattern
reflects the fact that the variable costs, and therefore total cost, increase first by decreas-
ing amounts and then by increasing amounts (see columns 3 and 4, Table 8-2).

MC AND MARGINAL PRODUCT

The shape of the marginal-cost curve is a consequence of the law of diminishing
returns. Looking back at Table 8-1, we can see the relationship between marginal
product and marginal cost. If all units of a variable resource (here labour) are hired
at the same price, the marginal cost of each extra unit of output will fall as long as
the marginal product of each additional worker is rising, because marginal cost is
the (constant) cost of an extra worker divided by his or her marginal product. There-
fore, in Table 8-1, suppose that each worker can be hired for $10. Because the first
worker’s marginal product is 10 units of output, and hiring this worker increases
the firm’s costs by $10, the marginal cost of each of these 10 extra units of output is
$1 (= $10 ÷ 10 units). The second worker also increases costs by $10, but the marginal
product is 15, so the marginal cost of each of these 15 extra units of output is $.67
(= $10 ÷ 15 units). Similarly, the MC of each of the 20 extra units of output con-
tributed by the third worker is $.50 (= $10 ÷ 20 units). To generalize, as long as mar-
ginal product is rising, marginal cost will fall.
With the fourth worker, diminishing returns set in and marginal cost begins to
rise. For the fourth worker, marginal cost is $.67 (= $10 ÷ 15 units); for the fifth
worker, MC is $1.00 ($10 ÷ 10 units); for the sixth, MC is $2,00 (= $10 ÷ 5 units), and
so on. If the price (cost) of the variable resource remains constant, increasing mar-
ginal returns will be reflected in a declining marginal cost, and diminishing marginal
 chapter eight • the organization and the costs of production 197

Key Graph FIGURE 8-5 THE RELATIONSHIP OF THE

MARGINAL-COST CURVE TO THE
AVERAGE-TOTAL-COST AND AVERAGE-
VARIABLE-COST CURVES
The marginal-cost (MC) curve cuts $200
through the average-total-cost (ATC)
curve and the average-variable-cost
(AVC) curve at their minimum points. MC
When MC is below average total 150
cost, ATC falls; when MC is above
average total cost, ATC rises.

Costs
Similarly, when MC is below average ATC
variable cost, AVC falls; when MC 100
is above average variable cost, AVC
AVC rises.

50

AFC

0 1 2 3 4 5 6 7 8 9 10 Q
Quantity

Quick Quiz
1. The marginal-cost curve first declines and then increases because of
a. increasing, then diminishing, marginal utility.
b. the decline in the gap between ATC and AVC as output expands.
c. increasing, then diminishing, marginal returns.
d. constant marginal revenue.

2. The vertical distance between ATC and AVC measures

a. marginal cost.
b. total fixed cost.
c. average fixed cost.
d. economic profit per unit.

3. ATC is
a. AVC – AFC.
b. MC + AVC.
c. AFC + AVC.
d. (AFC + AVC) × Q.

4. When the marginal-cost curve lies

a. above the ATC curve, ATC rises.
b. above the AVC curve, ATC rises.
c. below the AVC curve, total fixed cost increases.
d. below the ATC curve, total fixed cost falls.

Answers
1. c; 2. c; 3. c; 4. a
198 Part Two • Microeconomics of Product Markets

FIGURE 8-6 THE RELATIONSHIP BETWEEN PRODUCTIVITY

CURVES AND COST CURVES
The marginal-cost

Average product and

(MC) curve and the

marginal product
average-variable-
cost (AVC) curve in
panel (b) are mirror
images of the mar-
ginal-product (MP)
and average-product
(AP) curves in panel AP
(a). Assuming that MP
labour is the only
variable input and 0 Quantity of labour
that its price (the (a) Production curves
wage rate) is con-
stant, then when
MP is rising, MC is
falling, and when MC
MP is falling, MC is AVC
Cost (dollars)

rising. Under the

same assumptions,
when AP is rising,
AVC is falling, and
when AP is falling,
AVC is rising.

0 Quantity of output
(b) Cost curves

returns in a rising marginal cost. The MC curve is a mirror reflection of the marginal-
product curve. As you can see in Figure 8-6, when marginal product is rising,
marginal cost is necessarily falling. When marginal product is at its maximum, mar-
ginal cost is at its minimum; when marginal product is falling, marginal cost is rising.

RELATION OF MC TO AVC AND ATC

Figure 8-5 shows that the marginal-cost curve MC intersects both the AVC and ATC
curves at their minimum points. As noted earlier, this marginal-average relationship
is a mathematical necessity, which a simple illustration will reveal. Suppose a base-
ball pitcher has allowed his opponents an average of three runs per game in the first
three games he has pitched. Now, whether his average falls or rises as a result of
pitching a fourth (marginal) game will depend on whether the additional runs he
allows in that extra game are fewer or more than his current three-run average. If in
the fourth game he allows fewer than three runs, for example one, his total runs will
rise from 9 to 10 and his average will fall from 3 to 2.5 (= 10 ÷ 4). Conversely, if in
the fourth game he allows more than three runs, say, seven, his total will increase
from 9 to 16 and his average will rise from 3 to 4 (= 16 ÷ 4).
So it is with costs. When the amount (the marginal cost) added to total cost is less
than the current average total cost, ATC will fall. Conversely, when the marginal
cost exceeds ATC, ATC will rise, which means that in Figure 8-5, as long as MC lies
below ATC, ATC will fall, and whenever MC lies above ATC, ATC will rise. At the
 chapter eight • the organization and the costs of production 199

point of intersection, where MC equals ATC, ATC has just stopped falling but has
not yet begun rising. This point, by definition, is the minimum point on the ATC
curve. The marginal-cost curve intersects the average-total-cost curve at the
ATC curve’s minimum point.
Marginal cost can be defined as the addition either to total cost or to total vari-
able cost resulting from one more unit of output; thus, this same rationale explains
why the MC curve also crosses the AVC curve at the AVC curve’s minimum point.
No such relationship exists between the MC curve and the average-fixed-cost curve,
because the two are not related; marginal cost includes only those costs that change
with output, and fixed costs by definition are those that are independent of output.
(Key Question 9)

Shifts of Cost Curves

Changes in either resource prices or technology will cause costs to change and there-
fore the cost curves to shift. If fixed costs double from $100 to $200, the AFC curve
in Figure 8-5 would shift upward. At each level of output, fixed costs are higher. The
ATC curve would also move upward, because AFC is a component of ATC. The
positions of the AVC and MC curves would be unaltered, because their locations are
based on the prices of variable rather than fixed resources. However, if the price
(wage) of labour or some other variable input rose, AVC, ATC, and MC would rise,
and those cost curves would all shift upward. The AFC curve would remain in place
because fixed costs have not changed. And, of course, reductions in the prices of
fixed or variable resources would reduce costs and product shifts of the cost curve
exactly opposite to those just described.
The discovery of a more efficient technology would increase the productivity of
all inputs, and the cost figures in Table 8-2 would all be lower. To illustrate, if labour
is the only variable input, if wages are $10 per hour, and if the average product is 10
units, then AVC would be $1. But if a technological improvement increases the aver-
age product of labour to 20 units, then AVC will decline to $.50. More generally, an
upward shift in the productivity curves shown in Figure 8-6(a) means a downward
shift in the cost curves portrayed in Figure 8-6(b). (See Global Perspective 8.1.)

8.1

140
Relative changes in average
labour costs in manufacturing, 130
Index (1992 = 100)

1992–1999, selected nations 120

Japan
Germany
Average labour costs (labour costs 110 U.K.
per unit of output) are a significant U.S. France
100
part of average total costs in most
industries. Average labour costs 90
have varied widely among nations 80 Canada
at various times in recent years. Other Italy
70
things equal, higher average labour 92 93 94 95 96 97 98 99
costs at each output level result in Source: U.S. Bureau of Labor Statistics,
higher ATC curves; lower average <www.bls.gov/>.
labour costs result in lower ATC curves.
200 Part Two • Microeconomics of Product Markets

● The law of diminishing returns indicates that,
beyond some point, output will increase by
diminishing amounts as more units of a variable
resource (labour) are added to a fixed resource
(capital).
● In the short run, the total cost of any level of
output is the sum of fixed and variable costs
(TC = TFC + TVC).
● Average fixed, average variable, and average
total costs are fixed, variable, and total costs
per unit of output; marginal cost is the extra
cost of producing one more unit of output.
● Average fixed cost declines continuously as out-
put increases; average-variable-cost and aver-
age-total-costs curves are U-shaped, reflecting
increasing and then diminishing returns; the
marginal-cost curve falls but then rises, inter-
secting both the average-variable-cost-curve
and the average-total-cost curve at their mini-
mum points.

Long-Run Production Costs

In the long run an industry and the individual firms it comprises can undertake all
desired resource adjustments. That is, they can change the amount of all inputs
used. The firm can alter its plant capacity; it can build a larger plant or revert to a
smaller plant than that assumed in Table 8-2. The industry also can change its plant
<hadm.sph.sc.edu/ size; the long run allows sufficient time for new firms to enter or for existing firms
Courses/Econ/Cost/ to leave an industry. We will discuss the impact of the entry and exit of firms to and
Cost.html> from an industry in the next chapter; here we are concerned only with changes in
A tutorial on total
cost, fixed cost,
plant capacity made by a single firm. Let’s couch our analysis in terms of average
variable cost, and total cost (ATC), making no distinction between fixed and variable costs because all
marginal cost resources, and therefore all costs, are variable in the long run.

Firm Size and Costs

Suppose a single-plant manufacturer begins on a small scale and, as the result of
successful operations, expands to successively larger plant sizes with larger output
capacities. What happens to average total cost as this occurs? For a time, succes-
sively larger plants will lower average total cost. However, eventually the building
of a still larger plant may cause ATC to rise.
Figure 8-7 illustrates this situation for five possible plant sizes. ATC-1 is the short-
run average-total-cost curve for the smallest of the five plants, and ATC-5 the curve
for the largest. Constructing larger plants will lower the minimum average total
costs through plant size 3, but then larger plants will mean higher minimum aver-
age total costs.

The Long-Run Cost Curve

The vertical lines perpendicular to the output axis in Figure 8-7 indicate those out-
puts at which the firm should change plant size to realize the lowest attainable aver-
age total costs of production. These are the outputs at which the per-unit costs for a
larger plant drop below those for the current, smaller plant. For all outputs up to 20
units, the lowest average total costs are attainable with plant size 1. However, if the
firm’s volume of sales expands to between 20 and 30 units, it can achieve lower per-
unit costs by constructing larger plant size 2. Although total cost will be higher at
 chapter eight • the organization and the costs of production 201

FIGURE 8-7 THE LONG-RUN AVERAGE-TOTAL-COST CURVE:

FIVE POSSIBLE PLANT SIZES
The long-run
average-total-cost
curve is made up of
segments of the ATC-4

Average total costs

short-run cost curves ATC-1 ATC-2
(ATC-1, ATC-2, etc.) ATC-3 ATC-5
of the various-size
plants from which the
firm might choose.
Each point on the
planning curve shows
the least unit cost
attainable for any
output when the firm
has had time to make
all desired changes in 0 20 30 50 60 Q
its plant size.
Output

the expanded levels of production, the cost per unit of output will be less. For any
output between 30 and 50 units, plant size 3 will yield the lowest average total costs.
From 50 to 60 units of output, the firm must build plant size 4 to achieve the lowest
unit costs. Lowest average total costs for any output over 60 units require construc-
tion of the still larger plant size 5.
Tracing these adjustments, we find that the long-run ATC curve for the enterprise
is made up of segments of the short-run ATC curves for the various plant sizes that
can be constructed. The long-run ATC curve shows the lowest average total cost at
which any output level can be produced after the firm has had time to make all appro-
priate adjustments in its plant size. In Figure 8-7 the dark blue, bumpy curve is the
firm’s long-run ATC curve or, as it is often called, the firm’s planning curve.
In most lines of production, the choice of plant size is much wider than in our
illustration. In many industries the number of possible plant sizes is virtually
unlimited, and in time quite small changes in the volume of output will lead to
changes in plant size. Graphically, this implies an unlimited number of short-run
ATC curves, one for each output level, as suggested by Figure 8-8 (Key Graph).
Then, rather than consisting of segments of short-run ATC curves as in Figure 8-7,
the long-run ATC curve is made up of all the points of tangency of the unlimited
number of short-run ATC curves from which the long-run ATC curve is derived.
Therefore, the planning curve is smooth rather than bumpy. Each point on it tells us
the minimum ATC of producing the corresponding level of output.

Economies and Diseconomies of Scale

We have assumed that for a time increasing plant sizes will lead to lower unit costs
but that beyond some point successively larger plants will mean higher average total
costs. That is, we have assumed that the long-run ATC curve is U-shaped. But why
should this be? Note, first, that the law of diminishing returns does not apply in the
long run because diminishing returns presumes one resource is fixed in supply, while
the long run means all resources are variable. Also, our discussion assumes resource
202 Part Two • Microeconomics of Product Markets

prices are constant. We can explain the U-shaped long-run average-total-cost curve
in terms of economies and diseconomies of large-scale production.

ECONOMIES OF SCALE
economies Economies of scale, or economies of mass production, explain the downsloping
of scale part of the long-run ATC curve. As plant size increases, a number of factors will for
Reductions in the a time lead to lower average costs of production.
average total cost of
producing a product Labour Specialization Increased specialization in the use of labour becomes more
as the firm expands achievable as a plant increases in size. Hiring more workers means jobs can be
the size of plant (its
output) in the long
divided and subdivided. Each worker may now have just one task to perform
run; the economies instead of five or six. Workers can work full time on those tasks for which they have
of mass production. special skills. In a small plant, skilled machinists may spend half their time per-
forming unskilled tasks, leading to higher production costs.
Further, by working at fewer tasks, workers become proficient at those tasks. The
jack-of-all-trades doing five or six jobs is not likely to be efficient in any of them. By
concentrating on one task, the same worker may become highly efficient.
Finally, greater labour specialization eliminates the loss of time that accompanies
each shift of a worker from one task to another.
Managerial Specialization Large-scale production also means better use of, and
greater specialization in, management. A supervisor who can handle 20 workers is
underused in a small plant that employs only 10 people. The production staff could
be doubled with no increase in supervisory costs.
Small firms cannot use management specialists to best advantage. In a small plant
sales specialists may have to divide their time between several executive functions, for
example, marketing, personnel, and finance. A larger scale of operations means that
the marketing expert can supervise marketing full time, while specialists perform
other managerial functions. Greater efficiency and lower unit costs are the net result.
Efficient Capital Small firms often cannot afford the most efficient equipment. In
many lines of production such machinery is available only in very large and
extremely expensive units. Furthermore, effective use of the equipment demands a
high volume of production, and that again requires large-scale producers.
In the automobile industry the most efficient fabrication method in North Amer-
ica employs robotics and elaborate assembly line equipment. Effective use of this
equipment demands an annual output of perhaps 200,000 to 400,000 automobiles.
Only very large-scale producers can afford to purchase and use this equipment effi-
ciently. The small-scale producer is faced with a dilemma. To fabricate automobiles
using other equipment is inefficient and, therefore, more costly per unit. The alter-
native of purchasing the efficient equipment and underusing it at low levels of out-
put is also inefficient and costly.
Other Factors Many products entail design and development costs, as well as other
start-up costs, that must be incurred irrespective of projected sales. These costs
decline per unit as output is increased. Similarly, advertising costs decline per auto,
per computer, per stereo system, and per box of detergent as more units are produced
and sold. The firm’s production and marketing expertise usually rises as it produces
and sells more output. This learning by doing is a further source of economies of scale.
All these factors contribute to lower average total costs for the firm that is able to
expand its scale of operations. Where economies of scale are possible, an increase in
all resources of, say, 10 percent will cause a more-than-proportionate increase in out-
put of, say, 20 percent. The result will be a decline in ATC.
 chapter eight • the organization and the costs of production 203

In many Canadian manufacturing industries, economies of scale have been of

great significance. Firms that have expanded their scale of operations to obtain
economies of mass production have survived and flourished. Those unable to
expand have become relatively high-cost producers, doomed to struggle to survive.

DISECONOMIES OF SCALE
In time the expansion of a firm may lead to diseconomies and, therefore, higher
average total costs.
dis- The main factor causing diseconomies of scale is the difficulty of efficiently con-
economies trolling and coordinating a firm’s operations as it becomes a large-scale producer.
of scale In a small plant a single key executive may make all the basic decisions for the
Increases in the
average total cost of
plant’s operation. Because of the firm’s small size, the executive is close to the pro-
producing a product duction line, understands the firm’s operations, and can digest information and
as the firm expands make efficient decisions.
the size of its plant This neat picture changes as a firm grows. Many management levels now come
(its output) in the between the executive suite and the assembly line; top management is far
long run.
removed from the actual production operations of the plant. One person cannot
assemble, digest, and understand all the information essential to decision making
on a large scale. Authority must be delegated to many vice-presidents, second
vice-presidents, and so forth. This expansion of the management hierarchy leads
to problems of communication and cooperation, bureaucratic red tape, and the
possibility that decisions will not be coordinated. Similarly, decision making may
be slowed down to the point that decisions fail to reflect changes in consumer
tastes or technology quickly enough. The result is impaired efficiency and rising
average total costs.
Also, in massive production facilities workers may feel alienated from their
employers and care little about working efficiently. Opportunities to shirk respon-
sibilities, by avoiding work in favour of on-the-job leisure, may be greater in large
plants than in small ones. Countering worker alienation and shirking may require
additional worker supervision, which increases costs.
Where diseconomies of scale are operative, an increase in all inputs of, say, 10
percent will cause a less-than-proportionate increase in output of, say, 5 percent. As
a consequence, ATC will increase. The rising portion of the long-run cost curves in
Figure 8-9 illustrates diseconomies of scale.
constant
returns
to scale The CONSTANT RETURNS TO SCALE
range of output In some industries a rather wide range of output may exist between the output at
between the output which economies of scale end and the output at which diseconomies of scale begin.
at which economies
of scale end and
That is, a range of constant returns to scale may exist over which long-run average
diseconomies of cost does not change. The q1q2 output range of Figure 8-9(a) is an example. Here a
scale begin. given percentage increase in all inputs of, say, 10 percent will cause a proportionate
10 percent increase in output. Thus, in this range ATC is constant.

Applications and Illustrations

<www.theshortrun.com/ The business world offers many examples of economies and diseconomies of scale.
classroom/glossary/ Here are just a few.
micro/costprofit.html>
Cost and profit SUCCESSFUL STARTUP FIRMS
summarized,
including constant The Canadian economy has greatly benefited over the past few decades by explo-
returns to scale sive growth of new startup firms. Where economies of scale are significant, such
204 Part Two • Microeconomics of Product Markets

Key Graph FIGURE 8-8 THE LONG-RUN AVERAGE-TOTAL-COST

CURVE: UNLIMITED NUMBER OF
PLANT SIZES
If the number of
possible plant sizes
is very large, the
long-run average-
total-cost curve

Average total costs

approximates a
smooth curve.
Economies of
scale, followed
by diseconomies Long-run
of scale, cause ATC
the curve to be
U-shaped.

0 Output Q

Quick Quiz
1. The unlabelled tinted curves in this figure illustrate the
a. long-run average-total-cost curves of various firms constituting the industry.
b. short-run average-total-cost curves of various firms constituting the industry.
c. short-run average-total-cost curves of various plant sizes available to a partic-
ular firm.
d. short-run marginal-cost curves of various plant sizes available to a particular
firm.

2. The unlabelled tinted curves in this figure derive their shapes from
a. decreasing, then increasing, short-run returns.
b. increasing, then decreasing, short-run returns.
c. economies, then diseconomies, of scale.
d. diseconomies, then economies, of scale.

3. The long-run ATC curve in this figure derives its shape from
a. decreasing, then increasing, short-run returns.
b. increasing, then decreasing, short-run returns.
c. economies, then diseconomies, of scale.
d. diseconomies, then economies, of scale.

4. The long-run ATC curve is often called the firm’s

a. planning curve.
b. capital-expansion path.
c. total-product curve.
d. production possibilities curve.

Answers
1. c; 2. b; 3. c; 4. a
 chapter eight • the organization and the costs of production 205

FIGURE 8-9 VARIOUS POSSIBLE LONG-RUN AVERAGE-TOTAL-

COST CURVES
In panel (a),
economies of scale
are rather rapidly Economies Constant returns Diseconomies

Average total costs

obtained as plant of scale to scale of scale
size rises, and disec-
onomies of scale are
not encountered until
a considerably large
scale of output has Long-run
been achieved. Thus, ATC
long-run average
total cost is constant
over a wide range of
output. In panel (b), 0 q1 q2
economies of scale Output
are extensive, and (a)
diseconomies of
scale occur only at
very large outputs.
Average total costs

Average total cost,

therefore, declines
over a broad range
of output. In panel (c),
economies of scale Long-run ATC
are exhausted
quickly, followed
immediately by disec-
onomies of scale.
Minimum ATC thus 0
Output
occurs at a relatively
low output. (b)
Average total costs

Long-run ATC

0
Output
(c)

firms can enjoy years or even decades of growth accompanied by lower average
total costs. That has been the case for such internationally recognized firms as Intel
(microchips), Starbucks (coffee), Ballard Power Systems (fuel cells), Microsoft (soft-
ware), Celestica (computer components), Dell (personal computers), Yahoo (Inter-
net search engine), Cisco Systems (Internet switching), Nortel Networks (fibre
optics), Federal Express (overnight delivery), and America Online (Internet access).
206 Part Two • Microeconomics of Product Markets

A major source of these economies of scale is the ability to spread huge product
development and advertising costs over an increasing number of units of output.
These firms also benefit from the greater specialization of labour, management, and
capital equipment permitted by larger firm size. In some cases, the full exploitation
of economies of scale is still continuing. For example, Bell Canada’s cost of deliver-
ing Internet access to each additional user is very low. Thus, its average total cost
probably will continue to fall as it signs up more subscribers.

THE VERSON STAMPING MACHINE

In 1996 Verson (a U.S. firm located in Chicago) introduced a 15-metre-tall metal-
stamping machine that is the size of a house and weighs as much as 12 locomotives.
This $30 million machine, which cuts and sculpts raw sheets of steel into automo-
bile hoods and fenders, enables automakers to make new parts in just five minutes
compared with eight hours for older stamping presses. A single machine is designed
to make five million auto parts a year. So, to achieve the cost saving from this
machine, an auto manufacturer must have sufficient auto production to use all these
parts. By allowing the use of this cost-saving piece of equipment, large firm size
achieves economies of scale.

THE DAILY NEWSPAPER

The daily newspaper is undoubtedly one of the economy’s great bargains. Think of
all the resources that are combined to produce it: reporters, delivery people, pho-
tographers, editors, management, printing presses, pulp mills, pulp mill workers,
ink manufacturers, forest-product firms, loggers, logging truck drivers, and on and
on. Yet, for 50¢ you can buy a high-quality newspaper in major cities.
The fundamental reason that newspapers have such low prices are the low costs
resulting from economies of scale. If only 100 or 200 people bought the paper each
day, the average cost of each paper would be exceedingly high because the overhead
(fixed) costs of producing the paper would be spread over so few readers. But when
publishers sell thousands or hundreds of thousands of newspapers each day, they
spread their overhead cost very widely. They also can fully use expensive but
highly efficient printing presses. For both reasons, the average total cost of a paper
sinks to a few dimes. Moreover, the greater the number of readers, the more money
advertisers are willing to pay for ad space. That added revenue helps keep the price
of the newspaper low.

GENERAL MOTORS
Executives of General Motors, the world’s largest auto producer, are well aware
of the realities of diseconomies of scale. Experts on the auto industry say GM’s
large size may be a liability; it is substantially larger than Ford and Daimler-
Chrysler and is larger than Toyota and Honda combined. Compared with these
competitors, GM has a cost disadvantage that may help explain its substantial
decline in long-term market share. Despite billions of dollars of investment in
modern equipment, GM still has the lowest productivity and the highest cost per
car in the industry.
To try to reduce scale diseconomies, GM has taken several actions. It has estab-
lished joint ventures (combined projects) with smaller foreign rivals such as Toyota
to reduce its production costs. It has created Saturn, a separate, stand-alone auto
manufacturing company. It has given each of its five automotive divisions (Chevro-
 chapter eight • the organization and the costs of production 207

let, Buick, Pontiac, Oldsmobile, and Cadillac) greater autonomy with respect to
styling, engineering, and marketing decisions to reduce the layers of managerial
approval required in decision making. Finally, GM has reorganized into a small-car
group and a midsize and luxury group to try to cut costs and bring new cars to the
market faster. Whether these actions will overcome GM’s diseconomies of scale
remains to be seen.

Minimum Efficient Scale and Industry Structure

Economies and diseconomies of scale are an important determinant of an industry’s
minimum structure. Here we introduce the concept of minimum efficient scale (MES), which
efficient is the lowest level of output at which a firm can minimize long-run average costs.
scale (mes) In Figure 8-9(a) that level occurs at q1 units of output. Because of the extended range
The lowest level of
output at which a
of constant returns to scale, firms producing substantially greater outputs could also
firm can minimize realize the minimum attainable average costs. Specifically, firms within the q1 to q2
long-run average range would be equally efficient, so we would not be surprised to find an industry
costs. with such cost conditions to be populated by firms of quite different sizes. The
apparel, food processing, furniture, wood products, snowboard, and small-
appliance industries are examples. With an extended range of constant returns to
scale, relatively large and relatively small firms can coexist in an industry and be
equally successful.
Compare this with Figure 8-9(b), where economies of scale prevail over a wide
range of output and diseconomies of scale appear only at very high levels of out-
put. This pattern of declining long-run average total cost may occur over an
extended range of output, as in the automobile, aluminum, steel, and other heavy
industries. The same pattern holds in several of the new industries related to infor-
mation technology, for example, computer microchips, operating system software,
and Internet service provision.
Given consumer demand, efficient production will be achieved with a few large-
scale producers. Small firms cannot realize the minimum efficient scale and will not
be able to compete. In the extreme, economies of scale might extend beyond the
natural market’s size, resulting in what is termed natural monopoly, a relatively rare mar-
monopoly An ket situation in which average total cost is minimized when only one firm produces
industry in which the particular good or service.
economies of scale
are so great that a
Where economies of scale are few and diseconomies come into play quickly, the
single firm can minimum efficient size occurs at a low level of output, as shown in Figure 8-9(c). In
produce the product such industries a particular level of consumer demand will support a large number
at a lower average of relatively small producers. Many retail trades and some types of farming fall into
total cost than if this category. So do certain kinds of light manufacturing, such as the baking, cloth-
more than one
firm produced the
ing, and shoe industries. Fairly small firms are as efficient as, or more efficient than,
product. large-scale producers in such industries.
Our point here is that the shape of the long-run average-total-cost curve is deter-
mined by technology and the economies and diseconomies of scale that result. The
shape of the long-run ATC curve, in turn, can be significant in determining whether
an industry is populated by a relatively large number of small firms or is dominated
by a few large producers, or lies somewhere in between.
We must be cautious in our assessment, because industry structure does not
depend on cost conditions alone. Government policies, the geographic size of mar-
kets, managerial strategy and skill, and other factors must be considered in explain-
ing the structure of a particular industry. (Key Question 12)
208 Part Two • Microeconomics of Product Markets

● Most firms have U-shaped long-run average-
total-cost curves, reflecting economies and then
diseconomies of scale.
● Economies of scale are the consequence of
greater specialization of labour and management,
more efficient capital equipment, and the spread-
ing of startup costs among more units of output.
● Diseconomies of scale are caused by the prob-
lems of coordination and communication that
arise in large firms.
● Minimum efficient scale is the lowest level of
output at which a firm’s long-run average total
cost is at a minimum.

IRRELEVANCY OF SUNK COSTS

Sunk costs should be disregarded in decision making.

There is an old saying: Don’t cry
over spilt milk. The message is
that once you have spilled a glass
of milk, there is nothing you can
do to recover it, so you should
forget about it and move on from
there. This saying has great rele-
vance to what economists call
sunk costs. Such costs are like
sunken ships on the ocean floor:
once these costs are incurred,
they cannot be recovered.
Let’s gain an understanding of
this idea by applying it first to con-
sumers and then to businesses.
Suppose you buy an expensive
ticket to an upcoming football
game, but the morning of the
game you wake up with a bad case
of the flu. Feeling miserable, you
step outside to find that the wind
chill is about –20 degrees. You ab-
solutely do not want to go to the
game, buy you remind yourself
that you paid a steep price for the
ticket. You call several people to
try to sell the ticket, but you soon
discover that no one is interested
in it, even at a discounted price.
You conclude that everyone who
wants a ticket has one.
Should you go to the game?
Economic analysis says that you
should not take actions for which
marginal cost exceeds marginal
benefit. In this situation, the price
you paid for the ticket is irrele-
vant to the decision; both mar-
ginal or additional costs and
marginal or additional benefit
are forward-looking. If the mar-
ginal cost of going to the game is
greater than the marginal bene-
fit, the best decision is to go back
to bed. This decision should be
the same whether you paid $2,
$20, or $200 for the game ticket,
because the price that you pay
for something does not affect is
marginal benefit. Once the ticket
has been purchased and cannot
be resold, its cost is irrelevant to
the decision to attend the game.
Since you absolutely do not want
to go, clearly the marginal cost
exceeds the marginal benefit of
the game.
Here is a second consumer
example. Suppose a family is on
vacation and stops at a roadside
stand to buy some apples. The
kids get back into the car and
bite into their apples, immedi-
ately pronouncing them “totally
mushy” and unworthy of an-
other bite. Both parents agree
that the apples are “terrible,”
but the father continues to eat
his, because, as he says, “We
paid a premium price for them.”
One of the older children replies,
“Dad, that is irrelevant.” Al-
though not stated very diplomat-
ically, the child is exactly right.
In making a new decision, you
should ignore all costs that are
not affected by the decision. The
prior bad decision (in retrospect)
to buy the apples should not dic-
tate a second decision for which
marginal benefit is less than
marginal cost.
Now let’s apply the idea of
sunk costs to firms. Some of a
firm’s costs are not only fixed (re-
curring, but unrelated to the level
of output) but are sunk (unrecov-
erable). For example, a nonre-
fundable annual lease payment
for the use of a store cannot be
 chapter eight • the organization and the costs of production 209

recouped once it has been paid.
A firm’s decision about whether
to move from the store to a more
profitable location does not de-
pend on the amount of time re-
maining on the lease. If moving
means greater profit, it makes
sense to move whether there are
300 days, 30 days, or 3 days left
on the lease.
Or, as another example, sup-
pose a firm spends $1 million on
R&D to bring out a new product,
only to discover that the product
sells very poorly. Should the firm
continue to produce the product
at a loss even when there is no
realistic hope for future success?
Obviously, it should not. In mak-
ing this decision, the firm real-
izes that the amount it has spent
in developing the product is irrel-
evant; it should stop production
of the product and cut its losses.
In fact, many firms have dropped
products after spending millions
of dollars on their development.
Examples are the quick decision
by Coca-Cola to drop its New
Coke and the eventual decision
by McDonald’s to drop its
McLean Burger.
Consider a final real-world ex-
ample. For decades, Boeing and
McDonnell Douglas were keen
rivals in the worldwide sale of
commercial airplanes. Each com-
pany spent billions of dollars on
R&D and marketing in an at-
tempt to gain competitive ad-
vantages over each other. Then,
in 1996 they suddenly merged.
Many observers wondered how
two fierce rivals who had spent
such huge amounts to compete
could suddenly forget the past
and agree to merge. But these
past efforts and expenditures
were irrelevant to the decision;
they were sunk costs. The for-
ward-looking decision led both
companies to conclude, each for
its own reasons, that the mar-
ginal benefit of a merger would
outweigh the marginal cost.
In short, if a cost has been in-
curred and cannot be partly or
fully recouped by some other
choice, a rational consumer or
firm should ignore it. Sunk costs
are irrelevant. Or, as the saying
goes, don’t cry over spilt milk.

chapter summary
1. The firm is the most efficient form of organ-
izing production and distribution. The main
goal of a firm is to maximize profit.
2. Sole proprietorships, partnerships, and cor-
porations are the major legal forms that busi-
ness enterprises may assume. Though
proprietorships dominate numerically, the
bulk of total output is produced by corpora-
tions. Corporations have grown to their posi-
tion of dominance in the business sector
primarily because they are characterized by
limited liability and can acquire money capi-
tal for expansion more easily than other
firms can.
3. Economic costs include all payments that
must be received by resource owners to
ensure a continued supply of needed re-
sources to a particular line of production.
Economic costs include explicit costs, which
flow to resources owned and supplied by
others, and implicit costs, which are pay-
ments for the use of self-owned and self-
employed resources. One implicit cost is a
normal profit to the entrepreneur. Economic
profit occurs when total revenue exceeds
total cost (= explicit costs + implicit costs,
including a normal profit).
4. In the short run a firm’s plant capacity is
fixed. The firm can use its plant more or less
intensively by adding or subtracting units of
various resources, but it does not have suffi-
cient time in the short run to alter plant size.
5. The law of diminishing returns describes
what happens to output as a fixed plant is
used more intensively. As successive units
of a variable resource such as labour are
added to a fixed plant, beyond some point
the marginal product associated with each
additional worker declines.
6. Because some resources are variable and
others are fixed, costs can be classified
as variable or fixed in the short run. Fixed
costs are independent of the level of output;
210 Part Two • Microeconomics of Product Markets

variable costs vary with output. The total cost
of any output is the sum of fixed and variable
costs at that output.
7. Average fixed costs, average variable costs,
and average total costs are fixed, variable,
and total costs per unit of output. Average
fixed cost declines continuously as output
increases because a fixed sum is being
spread over an increasing number of units of
production. A graph of average variable cost
is U-shaped, reflecting the law of diminish-
ing returns. Average total cost is the sum of
average fixed and average variable costs; its
graph is also U-shaped.
8. Marginal cost is the extra, or additional, cost
of producing one more unit of output. It is the
amount by which total cost and total variable
cost change when one more or one fewer
unit of output is produced. Graphically, the
marginal-cost curve intersects the ATC and
AVC curves at their minimum points.
9. Lower resource prices shift cost curves
downward, as does technological progress.
Higher input prices shift cost curves upward.
10. The long run is a period of time sufficiently
long for a firm to vary the amounts of all
resources used, including plant size. In the
long run all costs are variable. The long-run
ATC, or planning, curve is composed of seg-
ments of the short-run ATC curves, and it
represents the various plant sizes a firm can
construct in the long run.
11. The long-run ATC curve is generally U-
shaped. Economies of scale are first en-
countered as a small firm expands. Greater
specialization in the use of labour and man-
agement, the ability to use the most efficient
equipment, and the spreading of startup
costs among more units of output all con-
tribute to economies of scale. As the firm
continues to grow, it will encounter dis-
economies of scale stemming from the
managerial complexities that accompany
large-scale production. The output ranges
over which economies and diseconomies
of scale occur in an industry are often an
important determinant of the structure of
that industry.

terms and concepts

plant, p. 181
firm, p. 181
industry, p. 181
sole proprietorship, p. 181
partnership, p. 181
corporation, p. 181
stocks, p. 183
bonds, p. 183
limited liability, p. 183
double taxation, p. 183
principle–agent problem,
p. 183
economic (opportunity) cost,
p. 184
explicit costs, p. 185
implicit costs, p. 185
normal profit, p. 185
economic profit, p. 186
short run, p. 187
long run, p. 187
total product (TP), p. 188
marginal product (MP), p. 188
average product (AP), p. 188
law of diminishing returns,
p. 188
fixed costs, p. 192
variable costs, p. 192
total cost, p. 192
average fixed cost (AFC),
p. 194
average variable cost (AVC),
p. 194
average total cost (ATC),
p. 195
marginal cost (MC), p. 195
economies of scale, p. 202
diseconomies of scale, p. 203
constant returns to scale,
p. 203
minimum efficient scale
(MES), p. 207
natural monopoly, p. 207

study questions
1. Distinguish between a plant, a firm, and an
industry. Why is an industry often difficult to
define?
2. KEY QUESTION What are the major
legal forms of business organization? Briefly
state the advantages and disadvantages of
each. How do you account for the dominant
role of corporations in the Canadian economy?
3. “The legal form an enterprise takes is dic-
tated primarily by the financial requirements
of its particular line of production.” Do you
agree? Why or why not?
4. KEY QUESTION Gomez runs a small
pottery firm. He hires one helper at $12,000
per year, pays annual rent of $5000 for his
shop, and spends $20,000 per year on
 chapter eight • the organization and the costs of production 211

materials. He has $40,000 of his own funds Plot the total, marginal, and average prod-
invested in equipment (pottery wheels, kilns, ucts and explain in detail the relationship
and so forth) that could earn him $4000 per between each pair of curves. Explain why
year if alternatively invested. He has been marginal product first rises, then declines,
offered $15,000 per year to work as a pot- and ultimately becomes negative. What
ter for a competitor. He estimates his en- bearing does the law of diminishing returns
trepreneurial talents are worth $3000 per have on short-run costs? Be specific. “When
year. Total annual revenue from pottery marginal product is rising, marginal cost is
sales is $72,000. Calculate the accounting falling. When marginal product is diminish-
profit and the economic profit for Gomez’s ing, marginal cost is rising.” Illustrate and
pottery firm. explain graphically.
5. Which of the following are short-run and 7. Why can the distinction between fixed costs
which are long-run adjustments? (a) Wendy’s and variable costs be made in the short run?
builds a new restaurant. (b) Acme Steel Cor- Classify the following as fixed or variable
poration hires 200 more workers. (c) A costs: advertising expenditures, fuel, interest
farmer increases the amount of fertilizer on company-issued bonds, shipping charges,
used on his corn crop. (d) An Alcan alu- payments for raw materials, real estate taxes,
minum plant adds a third shift of workers. executive salaries, insurance premiums, wage
6. KEY QUESTION Complete the fol- payments, depreciation and obsolescence
lowing table by calculating marginal product charges, sales taxes, and rental payments
and average product from the data given. on leased office machinery. “There are no
fixed costs in the long run; all costs are vari-
able.” Explain.
Inputs of Total Marginal Average
lalbour product product product 8. List several fixed and variable costs associ-
ated with owning and operating an automo-
0 0 bile. Suppose you are considering whether
1 15 ______ ______ to drive you car or fly 1000 kilometres for
spring break. Which costs—fixed, variable,
2 34 ______ ______ or both—would you take into account in
3 51 ______ ______ making your decision? Would any implicit
4 65 ______ ______ costs be relevant? Explain.
5 74 ______ ______ 9. KEY QUESTION A firm has $60 in
6 80 ______ ______ fixed costs and variable costs as indicated in
the table below. Complete the table; check
7 83 ______ ______ your calculations by referring to question 4
8 82 ______ ______ at the end of Chapter 9.

Total Total Average Average Average

Total fixed variable Total fixed variable total Marginal
product cost cost cost cost cost cost cost

0 $______ $ 0 $______ $______ $______ $______ $______

1 ______ 45 ______ ______ ______ ______ ______
2 ______ 85 ______ ______ ______ ______ ______
3 ______ 120 ______ ______ ______ ______ ______
4 ______ 150 ______ ______ ______ ______ ______
5 ______ 185 ______ ______ ______ ______ ______
6 ______ 225 ______ ______ ______ ______ ______
7 ______ 270 ______ ______ ______ ______ ______
8 ______ 325 ______ ______ ______ ______ ______
9 ______ 390 ______ ______ ______ ______ ______
10 ______ 465 ______ ______ ______ ______ ______
212 Part Two • Microeconomics of Product Markets
a. Graph total fixed cost, total variable cost,
and total cost. Explain how the law of
diminishing returns influences the shapes
of the variable-cost and total-cost curves.
b. Graph AFC, AVC, ATC, and MC. Explain
the derivation and shape of each of these
four curves and their relationships to one
another. Specifically, explain in nontech-
nical terms why the MC curve intersects
both the AVC and ATC curves at their
minimum points.
c. Explain how the location of each curve
graphed in question 7b would be altered
if (1) total fixed cost had been $100 rather
than $60, and (2) total variable cost had
been $10 less at each level of output.
10. Indicate how each of the following would
shift the (1) marginal-cost curve, (2) average-
variable-cost curve, (3) average-fixed-cost
curve, and (4) average-total-cost curve of a
manufacturing firm. In each case specify the
direction of the shift.
a. A reduction in business property taxes
b. An increase in the nominal wages of pro-
duction workers
c. A decrease in the price of electricity
d. An increase in insurance rates on plant
and equipment
e. An increase in transportation costs
internet application questions
1. Check out the National Post 500 list of
the largest Canadian firms at <www.
nationalpostbusiness.com/datamining/top500/
top500.htm>. From the top ten profit list, select
three firms from three different industries
and discuss the likely sources of economies
of scale that underlie their large size.
2. Use the Yahoo search engine at <www.
yahoo.ca> to locate a company’s homepage
11. Suppose a firm has only three possible
plant-size options, represented by the ATC
curves shown in the accompanying figure.
What plant size will the firm choose in pro-
ducing (a) 50, (b) 130, (c) 160 and (d) 250
units of output? Draw the firm’s long-run
average-cost curve on the diagram and
describe this curve.
ATC
ATC 3
ATC 2
ATC1
0
80 150 240 Q
12. KEY QUESTION Use the concepts of
economies and diseconomies of scale to
explain the shape of a firm’s long-run ATC
curve. What is the concept of minimum effi-
cient scale? What bearing can the shape of
the long-run ATC curve have on the structure
of an industry?
13. (The Last Word) What is a sunk cost? Provide
an example of a sunk cost other than one
from the text. Why are such costs irrelevant
in making decisions about future actions?
of your choice. Find and review the com-
pany’s income statement in its annual report
and classify the nonrevenue items as either
fixed or variable costs. Are all costs clearly
identifiable as either fixed or variable? What
item would be considered as accounting
profit? Would economic profit be higher or
lower than this accounting profit?
 NINE

Pure
Competition

I
n Chapter 7 we examined the relationship

between product demand and total rev-

enue, and in Chapter 8 we discussed costs

IN THIS CHAPTER
of production. Now we want to put revenues
Y OU WILL LEARN:
and costs together to see how a business
The four basic market
structures and how they decides what price to charge and how much
determine the degree of
competition among firms. output to produce. A firm’s decisions con-
•
The four conditions required for cerning price and production depend greatly
perfectly competitive markets.
• on the character of the industry in which it
The profit-maximizing output
is operating; there is no average or typical
in the short-run for a firm
in pure competition. industry. At one extreme is a single producer
•
About the marginal cost and that dominates the market; at the other
the short-run supply curve.
• extreme are industries in which thousands of
About the firm’s profit
maximization in the long run. firms each produce a minute fraction of mar-
•
That in competitive markets ket supply. Between these extremes are many
firms attain both allocative and
other industries.
productive efficiency.
214 Part Two • Microeconomics of Product Markets

Since we cannot examine each industry individually, we will focus on several basic
models of market structure to help you understand how price and output are deter-
mined in the many product markets in the economy. The models will also help you
to assess the efficiency or inefficiency of those markets.

Four Market Models

pure Economists group industries into four distinct market structures: pure competi-
competition tion, pure monopoly, monopolistic competition, and oligopoly. These four market
A market structure models differ in several respects: the number of firms in the industry, whether
in which a very large
number of firms
those firms produce a standardized product or try to differentiate their products
produce a standard- from those of other firms, and how easy or how difficult it is for firms to enter the
ized product. industry.
Very briefly the four models are as follows:
pure
monopoly A ● Pure competition is a market structure that requires a very large number of
market structure in firms producing a standardized product (that is, a product identical to that of
which one firm is other producers, such as corn or cucumbers). New firms can enter the indus-
the sole seller of a
product or service.
try very easily.
● Pure monopoly is a market structure in which one firm is the sole seller of a
monopolistic product or service (for example, a local cable company). Since the entry of
competition
A market structure additional firms is blocked, one firm constitutes the entire industry. Because
in which a relatively the monopolist produces a unique product, it makes no effort to differentiate
large number of its product.
sellers produce
differentiated ● Monopolistic competition is characterized by a relatively large number of
products. sellers producing differentiated products (clothing, furniture, books). There is
widespread nonprice competition, a selling strategy in which one firm tries to
oligopoly A distinguish its product or service from all competing products based on attrib-
market structure in
which a few large utes like design and quality (an approach called product differentiation). Entry
firms produce homo- to monopolistically competitive industries is quite easy.
geneous or differen-
tiated products. ● Oligopoly involves only a few sellers of an identical or similar product; con-
sequently each firm is affected by the decisions of its rivals and must take those
imperfect decisions into account when determining its own price and output.
competition
The market models Table 9-1 summarizes the characteristics of the four models for easy comparison. In
of pure monopoly, discussing these four market models, we will occasionally distinguish the charac-
monopolistic com- teristics of a pure competition from those of the three other basic market structures,
petition, and oligop-
oly considered as
which together we will designate as imperfect competition.
a group.

Pure Competition: Characteristics

and Occurrence
Let’s take a fuller look at pure competition, the focus of the remainder of this chapter.
● Very large numbers A basic feature of a purely competitive market is the pres-
ence of a large number of sellers acting independently, often offering their
products in large national or international markets. Examples include markets
for farm commodities, the stock market, and the foreign exchange market.
 chapter nine • pure competition 215

TABLE 9-1 CHARACTERISTICS OF THE FOUR BASIC

MARKET MODELS
MARKET MODEL
Monopolistic
Characteristic Pure competition competition Oligopoly Pure monopoly

Number of firms A very large Many Few One

number
Type of product Standardized Differentiated Standardized or Unique; no close
differentiated substitutes
Control over price None Some, but within Limited by mutual Considerable
rather narrow interdependence;
limits considerable with
collusion
Conditions of Very easy, no Relatively easy Significant Blocked
entry obstacles obstacles
Nonprice None Considerable Typically a great Mostly public
competition emphasis on deal, particularly relations
advertising, brand with product advertising
names, trademarks differentiation
Examples Agriculture Retail trade, Steel, automobiles, Local utilities
dresses, shoes farm implements,
many household
appliances

● Standardized product Purely competitive firms produce a standardized (or

homogeneous) product. As long as the price is the same, consumers will be
indifferent about which seller to buy the product from. Buyers view the prod-
ucts of firms B, C, D, and E as perfect substitutes for the product of firm A.
Because purely competitive firms sell standardized products, they make no
attempt to differentiate their products and do not engage in other forms of
nonprice competition.
● Price-takers In purely competitive markets individual firms exert no signif-
icant control over product price. Each firm produces such a small fraction of
total output that increasing or decreasing its output will not perceptively
influence total supply or, therefore, product price. In short, the competitive
price-taker firm is a price-taker: it cannot change market price, it can only adjust to it. That
A firm in a purely means that the individual competitive producer is at the mercy of the market.
competitive market Asking a price higher than the market price would be futile; consumers will
that cannot change
market price, only not buy from firm A at $2.05 when its 9999 competitors are selling an identical
adjust to it. product at $2 per unit. Conversely, because firm A can sell as much as it
chooses at $2 per unit, it has no reason to charge a lower price, say, $1.95, for
to do so would lower its profit.
● Free entry and exit New firms can freely enter, and existing firms can freely
leave, purely competitive industries. No significant legal, technological, finan-
cial, or other obstacles prohibit new firms from selling their output in any com-
petitive market.
216 Part Two • Microeconomics of Product Markets

Relevance of Pure Competition

Although pure competition is relatively rare in the real world, this market model is
highly relevant. A few industries more closely approximate pure competition than
any other market structure. In particular, we can learn much about markets for agri-
<n103dept.matc.edu/ cultural goods, fish products, foreign exchange, basic metals, and stock shares by
walshj/chrono/
studying the pure competition model. Also, pure competition is a meaningful start-
Chrono%202/
purecomp3.htm> ing point for any discussion of price and output determination. The operation of a
A quick summary of purely competitive economy provides a standard, or norm, for evaluating the effi-
pure competition ciency of the real-world economy.

Demand for a Purely Competitive Seller

To develop a tabular and graphical model of pure competition, we first examine
demand from a competitive seller’s viewpoint and see how it affects revenue. This
seller might be a wheat farmer, a strawberry grower, or a sheep rancher. Each purely
competitive firm offers only a negligible fraction of total market supply, therefore, it
average must accept the price determined by the market; it is a price-taker, not a price-maker.
revenue Total
revenue from the
sale of a product Perfectly Elastic Demand
divided by the
quantity of the The demand curve of the competitive firm, as represented by columns 1 and 2 in
product sold. Table 9-2, is perfectly elastic. As shown in the table, the market price is $131. The
firm represented cannot obtain a higher price by
restricting its output, nor does it need to lower
TABLE 9-2 THE DEMAND its price to increase its sales volume.
AND REVENUE We are not saying that market demand is per-
SCHEDULES fectly elastic in a competitive market. Market
FOR A PURELY demand graphs are the usual downsloping
COMPETITIVE FIRM curve, as a glance ahead at Figure 9-7(b) will
reveal. In fact, the total-demand curves for most
FIRM’S DEMAND FIRM’S
agricultural products are quite inelastic, even
SCHEDULE REVENUE DATA
though agriculture is the most competitive
(1) (2) (3) (4)
industry in the Canadian economy. An entire
Product Quantity Total Marginal
price, P demanded, revenue, revenue, industry (all firms producing a particular
(average Q TR MR product) can affect price by changing industry
revenue) (1) × (2) output. For example, all firms, acting inde-
pendently but simultaneously, can increase
$131 0 $ 0
$131 price by reducing output, but the individual
131 1 131 firm cannot do that. So the demand schedule
131
131 2 262 faced by the individual firm in a purely compet-
131
131 3 393 itive industry is perfectly elastic at the market
131 price, as shown in Figure 9-1.
131 4 524
131
131 5 655
131 Average, Total, and Marginal Revenue
131 6 786
131
131 7 917 The firm’s demand schedule is also its revenue
131 schedule. The price per unit to the purchaser is
131 8 1,048
131 also revenue per unit, or average revenue, to
131 9 1,179
131 the seller. To say that all buyers must pay $131
131 10 1,310
per unit is to say that the revenue per unit, or
average revenue, received by the seller is $131.
 chapter nine • pure competition 217

FIGURE 9-1 DEMAND, MARGINAL REVENUE, AND TOTAL

REVENUE OF A PURELY COMPETITIVE FIRM
A purely competitive
firm can sell addi-
tional units of output $1,179 TR
at the market price,
and thus its marginal- 1,048
revenue curve (MR)
coincides with its 917

Price and revenue

perfectly elastic
demand curve (D). 786
The firm’s total-
revenue curve (TR) 655
is a straight upward-
sloping line. 524

393

262
D = MR
131

0 2 4 6 8 10 12
Quantity demanded (sold)

total The total revenue for each sales level is found by multiplying price by the corre-
revenue The sponding quantity the firm can sell. (Column 1 multiplied by column 2 in Table 9-2
total number of dol- yields column 3.) In this case, total revenue increases by a constant amount, $131,
lars received by a
firm from the sale for each additional unit of sales. Each unit sold adds exactly its constant price to
of a product. total revenue.
When a firm is pondering a change in its output, it will consider how its total rev-
enue will change as a result. What will be the additional revenue from selling
marginal another unit of output? Marginal revenue is the change in total revenue, that is,
revenue The the extra revenue, that results from selling one more unit of output. In column 3,
change in total rev- Table 9-2, total revenue is zero when zero units are sold. The first unit of output
enue that results
from selling one sold increases total revenue from zero to $131; marginal revenue for that unit is
more unit of a firm’s $131. The second unit sold increases total revenue from $131 to $262, and marginal
product. revenue is again $131. Note in column 4 that, as is price, marginal revenue is a
constant $131. In pure competition, marginal revenue and price are equal. (Key
Question 3)

Graphical Portrayal
Figure 9-1 shows the purely competitive firm’s demand curve and total-revenue and
marginal-revenue curves. The demand curve (D) is horizontal, indicating perfect
price elasticity. The marginal-revenue curve (MR) coincides with the demand curve,
because the product price (and hence MR) is constant. Total revenue (TR) is a
straight line that slopes upward to the right. Its slope is constant because each extra
unit of sales increases TR by $131.
218 Part Two • Microeconomics of Product Markets

● In a purely competitive industry a large number
of firms produce a standardized product and no
significant barriers to entry exist.
● The demand of a competitive firm is perfectly
elastic—horizontal on a graph—at the market
price.
● Marginal revenue and average revenue for a
competitive firm coincide with the firm’s de-
mand curve; total revenue rises by the product
price for each additional unit sold.

Profit-Maximization in the Short Run

Since the purely competitive firm is a price-taker, it can maximize its economic profit
(or minimize its loss) only by adjusting its output. In the short run, the firm has a
fixed plant. Thus, it can adjust its output only through changes in the amount of
variable resources (materials, labour) it uses. It adjusts its variable resources to
achieve the output level that maximizes its profit.
There are two ways to determine the level of output at which a competitive firm
will realize maximum profit or the minimum amount of loss. One method is to com-
pare total revenue and total cost; the other is to compare marginal revenue and mar-
ginal cost. Both approaches apply to all firms, whether they are pure competitors,
pure monopolists, monopolistic competitors, or oligopolists.1

Total-Revenue–Total-Cost Approach: Profit-Maximization Case

With the market price of its product given by the market, the competitive producer
will ask: (1) Should we produce this product? (2) If so, in what amount? (3) What
economic profit (or loss) will we realize?
Let’s demonstrate how a firm in pure competition answers these questions, given
certain cost data and a specific market price. Our cost data are already familiar to
you because they are the fixed-cost, variable-cost, and total-cost data in Table 8-2,
repeated in columns 1 to 4 in Table 9-3. (Recall that these data reflect explicit and
implicit costs, including a normal profit.) Assuming that the market price is $131,
the total revenue for each output level is found by multiplying output (total prod-
uct) by price. Total revenue data are in column 5. Then in column 6 we find the profit
or loss at each output level by subtracting total cost, TC (column 4), from total rev-
enue, TR (column 5).
Should the firm produce? Definitely. It can realize a profit by doing so. How
much should it produce? Nine units. Column 6 tells us that this is the output at
which total economic profit is at a maximum. What economic profit (or loss) will the
firm realize? A $299 economic profit—the difference between total revenue ($1,179)
and total cost ($880).
Figure 9-2(a) compares total revenue and total cost graphically for this profit-
maximizing case. Observe again that the total revenue curve for a purely competitive

1
To make sure you understand these two approaches, we will apply them both to output deter-
mination under pure competition, but since we want to emphasize the marginal approach, we will
limit our graphical application of the total-revenue approach to a situation where the firm maxi-
mizes profits. We will then use the marginal approach to examine three cases: profit maximiza-
tion, loss minimization, and shutdown.
 chapter nine • pure competition 219

TABLE 9-3 THE PROFIT-MAXIMIZING OUTPUT FOR A PURELY

COMPETITIVE FIRM: TOTAL-REVENUE–TOTAL-COST
APPROACH (PRICE $131)
PRICE: $131
(1) (2) (3) (4) (5) (6)
Total Total Total Total Total Profit (+)
product fixed cost, variable cost, cost, revenue, or loss (–)
(output), Q TFC TVC TC TR

0 $100 $ 0 $ 100 $ 0 $–100

1 100 90 190 131 – 59
2 100 170 270 262 – 8
3 100 240 340 393 + 53
4 100 300 400 524 +124
5 100 370 470 655 +185
6 100 450 550 786 +236
7 100 540 640 917 +277
8 100 650 750 1,048 +298
9 100 780 880 1,179 +299
10 100 930 1,030 1,310 +280

firm is a straight line (Figure 9-2). Total cost increases with output in that more pro-
duction requires more resources, but the rate of increase in total cost varies with the
relative efficiency of the firm. Specifically, the cost data reflect Chapter 8’s law of
diminishing marginal returns. From zero to four units of output, total cost increases
at a decreasing rate as the firm uses its fixed resources more efficiently. With addi-
tional output, total cost begins to rise by ever-increasing amounts because of the
diminishing returns accompanying more intensive use of the plant.
Total revenue and total cost are equal where the two curves in Figure 9-2(a) inter-
sect (at roughly two units of output). Total revenue covers all costs (including a nor-
mal profit, which is included in the cost curve) but there is no economic profit. For
break-even this reason economists call this output a break-even point: an output at which a
point An output firm makes a normal profit but not an economic profit. If we extended the data
at which a firm beyond 10 units of output, another break-even point would occur where total cost
makes a normal
profit but not an
would catch up with total revenue somewhere between 13 and 14 units of output
economic profit. in Figure 9-2(a). Any output between the two break-even points identified in the fig-
ure will produce an economic profit. The firm achieves maximum profit, how-
ever, where the vertical distance between the total-revenue and total-cost curves is
greatest. For our particular data, this is at nine units of output, where maximum
profit is $299.
The profit-maximizing output is easier to see in Figure 9-2(b), where total eco-
nomic profit is graphed for each level of output. Where the total-revenue and total-
cost curves intersect in Figure 9-2(a), economic profit is zero, as shown by the
total-profit line in Figure 9-2(b). Where the vertical distance between TR and TC is
greatest in the upper graph, economic profit is at its peak ($299), as shown in the
lower graph. This firm will choose to produce nine units, since that output maxi-
mizes its profit.
220 Part Two • Microeconomics of Product Markets

FIGURE 9-2 TOTAL-REVENUE–TOTAL-COST APPROACH TO PROFIT

MAXIMIZATION FOR A PURELY COMPETITIVE FIRM
Panel (a): The firm’s
profit is maximized
at that output (nine Break-even point
$1,700 (normal profit)
units) where total
revenue, TR, exceeds 1,600
total cost, TC, by the 1,500
maximum amount. Total revenue, TR
Panel (b): The vertical 1,400

Total revenue and total cost

distance between TR 1,300
and TC in panel (a) is Maximum Total cost, TC
plotted as a total- 1,200
economic
economic-profit 1,100 profit
curve. Maximum eco- 1,000 $299
nomic profit is $299 at
nine units of output. 900
800
700 P = $131
600
500
400
300
Break-even point
200 (normal profit)
100

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14
Quantity demanded (sold)
(a) Profit-maximizing case
Total economic profit

$500
400 $299
Total economic
300
profit
200
100

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14
Quantity demanded (sold)
(b) Total economic profit

Marginal-Revenue–Marginal-Cost Approach
Choosing
In the second approach, the firm compares the amounts that each additional unit of
a Little More output would add to total revenue and to total cost. In other words, the firm com-
or Less
pares the marginal revenue (MR) and the marginal cost (MC) of each successive unit
of output. The firm will produce any unit of output whose marginal revenue
 chapter nine • pure competition 221

exceeds its marginal cost because the firm would gain more in revenue from selling
that unit than it would add to its costs by producing it. Conversely, if the marginal
cost of a unit of output exceeds its marginal revenue, the firm will not produce that
unit. Producing it would add more to costs than to revenue and profit would
decline or loss would increase.

MR = MC RULE
In the initial stages of production, where output is relatively low, marginal revenue
will usually (but not always) exceed marginal cost. So it is profitable to produce
through this range of output. But at later stages of production, where output is rel-
atively high, rising marginal costs will exceed marginal revenue. Obviously, a profit-
maximizing firm will want to avoid output levels in that range. Separating these
two production ranges is a unique point at which marginal revenue equals marginal
cost. This point is the key to the output-determining rule: In the short run, the firm will
maximize profit or minimize loss by producing the output at which marginal revenue equals
mr = mc marginal cost. This profit-maximizing guide is known as the MR = MC rule. (For
rule A method most sets of MR and MC data, MR and MC will be precisely equal at a fractional
of determining the level of output. In such instances the firm should produce the last complete unit of
total output at
which economic
output for which MR exceeds MC.)
profit is at a maxi-
mum (or losses at THREE CHARACTERISTICS OF THE MR = MC RULE
a minimum). Keep in mind these three features of the MR = MC rule:
1. The rule applies only if producing is preferable to shutting down. We will show
shortly that if marginal revenue does not equal or exceed average variable cost,
the firm will prefer to shut down rather than produce the MR = MC output.
2. The rule is an accurate guide to profit maximization for all firms whether they are
purely competitive, monopolistic, monopolistically competitive, or oligopolistic.
3. The rule can be restated as P = MC when applied to a purely competitive firm.
Because the demand schedule faced by a competitive seller is perfectly elastic at
the going market price, product price and marginal revenue are equal. So under
pure competition (and only under pure competition) we may substitute P for MR
in the rule; when producing is preferable to shutting down, the competitive firm should
produce at that point where price equals marginal cost (P = MC).
Now let’s apply the MR = MC rule or, because we are considering pure competition,
the P = MC rule, first using the same price as in our total-revenue–total-cost approach
to profit maximization. Then, by considering other prices, we will demonstrate two
additional cases: loss minimization and shut down. It is crucial that you understand the
MR = MC analysis that follows since it reappears in Chapters 10 and 11.

PROFIT-MAXIMIZING CASE
The first five columns in Table 9-4 reproduce the AFC, AVC, ATC, and MC data
derived for our product in Table 8-2. It is the marginal-cost data of column 5 that we
will compare with price (equals marginal revenue) for each unit of output. Suppose
first that the market price, and therefore marginal revenue, is $131, as shown in
column 6.
What is the profit-maximizing output? Every unit of output up to and including
the ninth unit represents greater marginal revenue than marginal cost of output.
Each of the first nine units, therefore, adds to the firm’s profit and will be produced.
222 Part Two • Microeconomics of Product Markets

TABLE 9-4 THE PROFIT-MAXIMIZING OUTPUT FOR A PURELY

COMPETITIVE FIRM: MARGINAL-REVENUE–
MARGINAL-COST APPROACH (PRICE = $131)
(1) (2) (3) (4) (5) (6) (7)
Total Average Average Average Marginal Price = Total economic
product fixed cost, variable total cost, cost, MC marginal profit (+)
(output) AFC cost, AVC ATC revenue, MR or loss (–)

0 $–100
1 $100.00 $90.00 $190.00 $ 90 $131 – 59
2 50.00 85.00 135.00 80 131 – 8
3 33.33 80.00 113.33 70 131 + 53
4 25.00 75.00 100.00 60 131 +124
5 20.00 74.00 94.00 70 131 +185
6 16.67 75.00 91.67 80 131 +236
7 14.29 77.14 91.43 90 131 +277
8 12.50 81.25 93.75 110 131 +298
9 11.11 86.67 97.78 130 131 +299
10 10.00 93.00 103.00 150 131 +280

The tenth unit, however, will not be produced. It would add more to cost ($150) than
to revenue ($131).

PROFIT CALCULATIONS
The economic profit realized by producing nine units can be calculated from the
average-total-cost data. Multiplying price ($131) by output (9), we find that total
revenue is $1179. Multiplying average total cost ($97.78) by output (9) gives us total
cost of $880.2 The difference of $299 (= $1179 – $880) is the economic profit. This firm
will prefer to operate rather than shut down.
Perhaps an easier way to calculate the economic profit is to determine the profit per
unit by subtracting the average total cost ($97.78) from the product price ($131) and
multiplying the difference (a per-unit profit of $33.22) by output (9). Take some time
now to verify the numbers in column 7 in Table 9-4. You will find that any output other
than those adhering to the MR = MC rule will mean either profits below $299 or losses.

GRAPHICAL PORTRAYAL
Figure 9-3 (Key Graph) shows price (= MR) and marginal cost graphically. Price
equals marginal cost at the profit-maximizing output of nine units. There the per-
unit economic profit is P – A, where P is the market price and A is the average total
cost for an output of nine units. The total economic profit is 9 × (P – A), shown by
the grey rectangular area.

2 Most of the unit-cost data are rounded figures. Therefore, economic profits calculated from them

will typically vary by a few cents from the profits determined in the total-revenue–total-cost
approach. Here we simply ignore the few-cents differentials to make our answers consistent with
the results of the total-revenue–total-cost approach.
 chapter nine • pure competition 223

Key Graph FIGURE 9-3 THE SHORT-RUN PROFIT-MAXIMIZING

POSITION OF A PURELY COMPETITIVE
FIRM
$200
The MR = MC output enables
the purely competitive firm to
maximize profits or to minimize P = $131 MR = MC
losses. In this case MR (= P in 150
MC

Cost and revenue

pure competition) and MC are
equal at an output Q of nine MR = P
units. There P exceeds the Economic profit
average total cost A = $97.78, 100 ATC
AVC
so the firm realizes an eco-
nomic profit of P – A per unit.
The total economic profit is A = $97.78
represented by the grey rec- 50
tangle and is 9 × (P – A).

0 1 2 3 4 5 6 7 8 9 10
Output

Quick Quiz
1. Curve MR is horizontal because
a. product price falls as output increases.
b. the law of diminishing marginal utility is at work.
c. the market demand for this product is perfectly elastic.
d. the firm is a price-taker.
2. At a price of $131 and 7 units of output
a. MR exceeds MC, and the firm should expand its output.
b. total revenue is less than total cost.
c. AVC exceeds ATC.
d. the firm would earn only a normal profit.
3. In maximizing profits at nine units of output, this firm is adhering to
which of the following decision rules?
a. Produce where MR exceeds MC by the greatest amount.
b. Produce where P exceeds ATC by the greatest amount.
c. Produce where total revenue exceeds total cost by the greatest amount.
d. Produce where average fixed costs are zero.
4. Suppose price declined from $131 to $100. This firm’s
a. marginal-cost curve would shift downward.
b. economic profit would fall to zero.
c. profit-maximizing output would decline.
d. total cost would fall by more than its total revenue.

Answers
1. d; 2. a; 3. c; 4. c
224 Part Two • Microeconomics of Product Markets

Note that the firm wants to maximize its total profit, not its per-unit profit. Per-
unit profit is greatest at seven units of output, where price exceeds average total cost
by $39.57 (= $131 – $91.43). But by producing only seven units, the firm would be
forgoing the production of two additional units of output that would clearly con-
tribute to total profit. The firm is happy to accept lower per-unit profits for addi-
tional units of output because they nonetheless add to total profit.

LOSS-MINIMIZING CASE
Now let’s assume that the market price is $81 rather than $131. Should the firm still
produce? If so, how much? What will be the resulting profit or loss? The answers,
respectively, are “Yes,” “Six units,” and “A loss of $64.”
The first five columns in Table 9-5 are the same as those in Table 9-4. Column 6
shows the new price (equal to MR), $81. Comparing columns 5 and 6, we find that the
first unit of output adds $90 to total cost but only $81 to total revenue. One might con-
clude: “Don’t produce—close down!” But that would be hasty. Remember that in the
very early stages of production, output is low, making marginal cost unusually high.
The price–marginal-cost relationship improves with increased production. For units
two through six, price exceeds marginal cost. Each of these five units adds more to
revenue than to cost, and as shown in column 7, they decrease the total loss. Together
they more than compensate for the loss taken on the first unit. Beyond six units, how-
ever, MC exceeds MR (= P). The firm should therefore produce six units. In general,
the profit-seeking producer should always compare marginal revenue (or price under
pure competition) with the rising portion of the marginal-cost schedule or curve.

LOSS DETERMINATION
Will production be profitable? No, because at six units of output the average total
cost of $91.67 exceeds the price of $81 by $10.67 per unit. If we multiply that by the

TABLE 9-5 THE LOSS-MINIMIZING OUTPUTS FOR A PURELY

COMPETITIVE FIRM: MARGINAL-REVENUE–MARGINAL-
COST APPROACH (PRICES = $81 AND $71)
(1) (2) (3) (4) (5) (6) (7) (8) (9)
Total Average Average Average Marginal $81 price = Profit (+) $71 price = Profit (+)
product fixed cost, variable total cost, cost, MC marginal or loss (–), marginal or loss (–),
(output) AFC cost, AVC ATC revenue, MR $81 price revenue, MR $71 price

0 $–100 $–100
1 $100.00 $90.00 $190.00 $ 90 $81 –109 $71 –119
2 50.00 85.00 135.00 80 81 –108 71 –128
3 33.33 80.00 113.33 70 81 – 97 71 –127
4 25.00 75.00 100.00 60 81 – 76 71 –116
5 20.00 74.00 94.00 70 81 – 65 71 –115
6 16.67 75.00 91.67 80 81 – 64 71 –124
7 14.29 77.14 91.43 90 81 – 73 71 –143
8 12.50 81.25 93.75 110 81 –102 71 –182
9 11.11 86.67 97.78 130 81 –151 71 –241
10 10.00 93.00 103.00 150 81 –220 71 –320
 chapter nine • pure competition 225

six units of output, we find the firm’s total loss is $64. Alternatively, comparing the
total revenue of $486 (= 6 × $81) with the total cost of $550 (= 6 × $91.67), we see
again that the firm’s loss is $64.
Then why produce? Because this loss is less than the firm’s $100 of fixed costs,
which is the $100 loss the firm would incur in the short run by closing down. The
firm receives enough revenue per unit ($81) to cover its average variable costs of $75
and also provide $6 per unit, or a total of $36, to apply against fixed costs. There-
fore, the firm’s loss is only $64 (= $100 – $36), not $100.

GRAPHICAL PORTRAYAL
This loss-minimizing case is shown graphically in Figure 9-4. Wherever price P
exceeds average variable cost, AVC, the firm can pay part, but not all, of its fixed
costs by producing. The loss is minimized by producing the output at which MC =
MR (here, six units). At that output, each unit contributes P – V to covering fixed
cost, where V is the AVC at six units of output. The per-unit loss is A – P = $10.67,
and the total loss is 6 × (A – P), or $64, as shown by the grey area.

SHUTDOWN CASE
Suppose now that the market yields a price of only $71. Should the firm produce?
No, because at every output the firm’s average variable cost is greater than the price
(compare columns 3 and 8 in Table 9-5). The smallest loss the firm can incur by pro-
ducing is greater than the $100 fixed cost it will lose by shutting down (as shown by
column 9). The best action is to shut down.
You can see this shutdown situation in Figure 9-5. Price comes closest to cover-
ing average variable costs at the MR (= P) = MC output of five units. But even here,
price or revenue per unit would fall short of average variable cost by $3 (= $74 –
$71). By producing at the MR (= P) = MC output, the firm would lose its $100 worth
of fixed cost plus $15 ($3 of variable cost on each of the five units), for a total loss of

FIGURE 9-4 THE SHORT-RUN LOSS-MINIMIZING POSITION OF A

PURELY COMPETITIVE FIRM
If price P exceeds the $200
minimum AVC (here
$74 at Q = 5) but is
less than ATC, the MC
MR = MC output (here 150
six units) will permit
Cost and revenue

the firm to minimize A = $91.67

its losses. In this
instance the loss is 100 ATC
A – P per unit, where AVC
Loss
A is the average total
cost at six units of MR = P
output. The total loss P = $81
is shown by the grey 50
V = $75
area and is equal to
6 × (A – P).

0 1 2 3 4 5 6 7 8 9 10
Output
226 Part Two • Microeconomics of Product Markets

FIGURE 9-5 THE SHORT-RUN SHUTDOWN POSITION OF A

PURELY COMPETITIVE FIRM
If price P falls below $200
the minimum AVC
(here $74 at Q = 5),
the competitive firm
MC
will minimize its 150

Cost and revenue

losses in the short
run by shutting down.
There is no level of
output at which the
100 ATC
firm can produce and
AVC
realize a loss smaller
than its total fixed
cost. MR = P
50 P = $71

0 1 2 3 4 5 6 7 8 9 10
Output

$115. This figure compares unfavourably with the $100 fixed-cost loss the firm
would incur by shutting down and producing no output. So, it will make sense for
the firm to shut down rather than produce at a $71 price—or at any price less than
the minimum average variable cost of $74.
The shutdown case reminds us of the qualifier to our MR (= P) = MC rule. A com-
petitive firm will maximize profit or minimize loss in the short run by producing
that output at which MR (= P) = MC, provided that market price exceeds minimum aver-
age variable cost.

Marginal Cost and Short-Run Supply

In the preceding section we simply selected three different prices and asked what
quantity the profit-seeking competitive firm, faced with certain costs, would choose
to offer in the market at each price. This set of product prices and corresponding
quantities supplied constitutes part of the supply schedule for the competitive firm.
Table 9-6 summarizes the supply schedule data for those three prices ($131, $81,
and $71) and four others. This table confirms the direct relationship between prod-
uct price and quantity supplied that we identified in Chapter 3. Note first that the
firm will not produce at price $61 or $71, because both are less than the $74 mini-
mum AVC. Then note that quantity supplied increases as price increases. Observe
finally that economic profit is higher at higher prices.

Generalized Depiction
Figure 9-6 (Key Graph) generalizes the MR = MC rule and the relationship between
short-run production costs and the firm’s supply behaviour. The ATC, AVC, and MC
curves are shown, along with several marginal-revenue lines drawn at possible mar-
ket prices. Let’s observe quantity supplied at each of these prices.
 chapter nine • pure competition 227

● Price P 1 is below the firm’s minimum

TABLE 9-6 THE SUPPLY average variable cost, so at this price the
SCHEDULE OF A firm won’t operate at all. Quantity sup-
COMPETITIVE FIRM plied will be zero, as it will be at all other
CONFRONTED prices below P2.
WITH THE COST
● Price P2 is just equal to the minimum aver-
DATA IN TABLE 9-4
age variable cost. The firm will supply Q2
Quantity Maximum profit (+) units of output (where MR2 = MC) and
Price supplied or minimum loss (–) just cover its total variable cost. Its loss
will equal its total fixed cost. (Actually, the
$151 10 $+480
firm would be indifferent as to shutting
131 9 +299 down or supplying Q2 units of output, but
111 8 +138 we assume it produces.)
91 7 – 3
● At price P3 the firm will supply Q3 units of
81 6 – 64 output to minimize its short-run losses.
71 0 –100 At any other price between P2 and P4 the
61 0 –100 firm will minimize its losses by producing
and supplying the quantity at which MR
(= P) = MC.
● The firm will just break even at price P4, where it will supply Q4 units of out-
put (where MR4 = MC), earning a normal profit but not an economic profit.
Total revenue will just cover total cost, including a normal profit, because the
revenue per unit (MR4 = P4) and the total cost per unit (ATC) are the same.
● At price P5 the firm will realize an economic profit by producing and supply-
ing Q5 units of output. In fact, at any price above P4 the firm will obtain eco-
nomic profit by producing to the point where MR (= P) = MC.
Note that each of the MR (= P) = MC intersection points labelled b, c, d, and e in Fig-
ure 9-6 indicates a possible product price (on the vertical axis) and the correspon-
ding quantity that the firm would supply at that price (on the horizontal axis). Thus,
points such as these are on the upsloping supply curve of the competitive firm.
Note, too, that quantity supplied would be zero at any price below the minimum
average variable cost (AVC). We can conclude that the portion of the firm’s mar-
ginal-cost curve lying above its average-variable-cost curve is its short-run supply
curve. In Figure 9-6, the solid segment of the marginal-cost curve MC is this firm’s
short-run short-run supply curve, which tells us the amount of output the firm will supply at
supply each price in a series of prices.
curve A curve
that shows the
quantities of the Diminishing Returns, Production Costs, and Product Supply
product a firm in a
purely competitive We have now identified the links between the law of diminishing returns (Chapter
industry will offer to 8), production costs, and product supply in the short run. Because of the law of
sell at various prices diminishing returns, marginal cost eventually rises as more units of output are
in the short run. produced. And because marginal cost rises with output, a purely competitive
firm must get successively higher prices to motivate it to produce additional units
of output.
Another way to look at it is that higher product prices and marginal revenue
encourage a purely competitive firm to expand output. As its output increases, the
firm’s marginal costs rise as a result of the law of diminishing returns. At some now
greater output, this higher MC equals the new product price and MR. Profit once
228 Part Two • Microeconomics of Product Markets

Key Graph FIGURE 9-6 THE P = MC RULE AND THE COMPETITIVE

FIRM’S SHORT-RUN SUPPLY CURVE
Application of the P = MC rule, as
modified by the shutdown case, MC
reveals that the (solid) segment
of the firm’s MC curve that lies e ATC
above AVC is the firm’s short-run P5 MR5

Cost and revenues (dollars)

supply curve. More specifically, Break-even
at price P1, P = MC at point a, but (normal profit) AVC
the firm will produce no output d point
because P1 is less than minimum P4 MR4
AVC. At price P2 the firm will oper-
ate at point b, where it produces c
Q2 units and incurs a loss equal to P3 MR3
its total fixed cost. At P3 it oper- b
ates at point c, where output is Q3 P2 MR2
and the loss is less than the total Shutdown point
a (if P is below)
fixed cost. With the price of P4,
P1 MR1
the firm operates at point d; in this
case the firm earns a normal profit
because at output Q4 price equals
ATC. At price P5 the firm operates
at point e and maximizes its eco-
nomic profit by producing Q5 units. 0 Q2 Q3 Q4 Q5
Quantity supplied

Quick Quiz
1. Which of the following might increase product price from P3 to P5?
a. An improvement in production technology
b. A decline in the price of a substitute good
c. An increase in the price of a complementary good
d. Rising incomes if the product is a normal good
2. An increase in price from P3 to P5 would
a. shift this firm’s MC curve to the right.
b. mean that MR5 exceeds MC at Q3 units, inducing the firm to expand output to Q5.
c. decrease this firm’s average variable costs.
d. enable this firm to obtain a normal, but not an economic, profit.
3. At P4
a. this firm has no economic profit.
b. this firm will earn only a normal profit and thus will shut down.
c. MR4 will be less than MC at the profit-maximizing output.
d. the profit-maximizing output will be Q5.
4. Suppose P4 is $10, P5 is $15, Q4 is 8 units, and Q5 is 10 units. This firm’s
a. supply curve is elastic over the Q4–Q5 range of output.
b. supply curve is inelastic over the Q4–Q5 range of output.
c. total revenue will decline if price rises from P4 to P5.
d. marginal-cost curve will shift downward if price falls from P5 to P4.
Answers
1. d; 2. b; 3. a; 4. b
 chapter nine • pure competition 229

again is maximized but at a greater quantity. Quantity supplied has increased in

direct response to an increase in product price and the desire to maximize profit.

Supply Curve Shifts

In Chapter 8 we saw that changes in such factors as the prices of variable inputs or
in technology will shift the marginal-cost or short-run supply curve to a new loca-
tion. All else being equal, a wage increase, for example, would shift the supply curve
in Figure 9-6 upward as viewed from the horizontal axis (leftward as viewed from
the vertical axis), constituting a decrease in supply. Similarly, technological progress
that increases the productivity of labour would shift the marginal-cost or supply
curve downward as viewed from the horizontal axis (rightward as viewed from the
vertical axis). This shift represents an increase in supply.

Firm and Industry: Equilibrium Price

In the preceding section we developed the competitive firm’s short-run supply
curve by applying the MR (= P) = MC rule. We now determine which of the various
possible prices will actually be the market equilibrium price.
From Chapter 3 we know that in a purely competitive market, equilibrium price
is determined by total, or market, supply and total demand. To derive total supply,
the supply schedules or curves of the individual competitive sellers must be added
up. Columns 1 and 3 in Table 9-7 repeat the supply schedule for the individual com-
petitive firm, as derived in Table 9-6. We now assume that there are 1000 competi-
tive firms in this industry, all having the same total and unit costs as the single firm
we discussed. This assumption lets us calculate the market supply schedule
(columns 2 and 3) by multiplying the quantity-supplied figures of the single firm
(column 1) by 1000.

MARKET PRICE AND PROFITS

To determine the equilibrium price and output, these total-supply data must be
compared with total-demand data. Let’s assume that total demand is as shown in
columns 3 and 4 in Table 9-7. By comparing the
total quantity supplied and the total quantity
TABLE 9-7 FIRM AND MARKET demanded at the seven possible prices, we
SUPPLY AND determine that the equilibrium price is $111 and
MARKET DEMAND the equilibrium quantity is 8000 units for the
industry—eight units for each of the 1000 iden-
(1) (2) (3) (4) tical firms.
Quantity Total Product Total quantity
supplied, quantity price demanded Will these conditions of market supply and
single firm supplied, demand make this a profitable or an unprof-
1000 firms itable industry? Multiplying produce price
($111) by output (8 units), we find that the total
10 10,000 $151 4,000 revenue of each firm is $888. The total cost is
9 9,000 131 6,000 $750, found by looking at column 4 in Table
8 8,000 111 8,000 9-3. The $138 difference is the economic profit
7 7,000 91 9,000 of each firm. For the industry, total economic
6 6,000 81 11,000 profit is $138,000. This, then, is a profitable
industry.
0 0 71 13,000
Another way of calculating economic profit
0 0 61 16,000 is to determine per-unit profit by subtracting
average total cost ($93.75) from product price
230 Part Two • Microeconomics of Product Markets

($111) and multiplying the difference (per-unit profit of $17.25) by the firm’s equi-
librium level of output (8). Again we obtain an economic profit of $138 per firm and
$138,000 for the industry.

GRAPHICAL PORTRAYAL
Figure 9-7 shows this analysis graphically. The individual supply curves of each of
the 1000 identical firms—one of which is shown as s = MC in Figure 9-7(a)—are
summed horizontally to get the total-supply curve S = ∑MC of Figure 9-7(b).
Together with total-demand curve D, it yields the equilibrium price $111 and equi-
librium quantity (for the industry) 8000 units. This equilibrium price is given and
unalterable to the individual firm; that is, each firm’s demand curve is perfectly elas-
tic at the equilibrium price, as indicated by d in Figure 9-7(a). Because the individ-
ual firm is a price-taker, the marginal-revenue curve coincides with the firm’s
demand curve d. This $111 price exceeds the average total cost at the firm’s equilib-
rium MR = MC output of eight units, so the firm earns an economic profit repre-
sented by the grey area in Figure 9-7(a).
Assuming costs or market demand do not change, these diagrams reveal a gen-
uine equilibrium in the short run. The market has no shortages or surpluses to cause
price or total quantity to change. Nor can any one firm in the industry increase its
profit by altering its output. Note, too, that higher unit and marginal costs on the
one hand, or weaker market demand on the other, could change the situation so that
Figure 9-7(a) resembles Figure 9-4 or Figure 9-5. In Figure 9-7(a) and (b), sketch how
higher costs or decreased demand could produce short-run losses.

FIRM VERSUS INDUSTRY

Figure 9-7 underscores a point made earlier: Product price is a given fact to the indi-
vidual competitive firm, but the supply plans of all competitive producers as a group
are a basic determinant of product price. If we recall the fallacy of composition,
we find there is no inconsistency here. Although one firm, supplying a negligible

FIGURE 9-7 SHORT-RUN COMPETITIVE EQUILIBRIUM FOR A FIRM

(PANEL A) AND THE INDUSTRY (PANEL B)
The horizontal sum of p P
the 1000 firms’ individual
supply curves (s) deter-
mines the industry s = MC S = Σ MC
supply curve (S). Given
industry demand (D), the
short-run equilibrium ATC
price and output for the
industry are $111 and
8000 units. Taking the $111 d $111
AVC
equilibrium price as Economic
given, the individual firm profit
establishes its profit- D
maximizing output at
eight units and, in this
case, realizes the eco-
nomic profit represented 0 8 q 0 8,000 Q
by the grey area. (a) Single firm (b) Industry
 chapter nine • pure competition 231

TABLE 9-8 OUTPUT DETERMINATION IN PURE COMPETITION

IN THE SHORT RUN
Question Answer

Should this firm produce?
What quantity should this
firm produce?
Will production result in
economic profit?
Yes, if price is equal to, or greater than, minimum average variable
cost. This means that the firm is profitable or that its losses are less
than its fixed cost.
Produce where MR (= P) = MC; there, profit is maximized (TR exceeds
TC by a maximum amount) or loss is minimized.
Yes, if price exceeds average total cost (TR will exceed TC). No, if
average total cost exceeds price (TC will exceed TR).

fraction of total supply, cannot affect price, the sum of the supply curves of all the
firms in the industry constitutes the industry supply curve, and that curve does
have an important bearing on price. (Key Question 4)

● Profit is maximized, or loss minimized, at the
output at which marginal revenue (or price in
pure competition) equals marginal cost.
● If the market price is below the minimum aver-
age variable cost, the firm will minimize its
losses by shutting down.
● The segment of the firm’s marginal-cost curve
that lies above the average-variable-cost curve
is its short-run supply curve.
● Table 9-8 summarizes the MR = MC approach to
determining the competitive firm’s profit-maxi-
mizing output. It also shows the equivalent
analysis in terms of total revenue and total cost.
● Under competition, equilibrium price is a given
to the individual firm and simultaneously is the
result of the production (supply) decisions of all
firms as a group.

Profit Maximization in the Long Run

In the short run a specific number of firms are in an industry, each with a fixed, unal-
terable plant. Firms may shut down in the sense that they can produce zero units of
output in the short run, but they do not have sufficient time to liquidate their assets
and go out of business. By contrast, in the long run firms already in an industry have
sufficient time either to expand or to contract their plant capacities. More important,
the number of firms in the industry may either increase or decrease as new firms
enter or existing firms leave. We now examine how these long-run adjustments
modify our conclusions concerning short-run output and price determination.

Assumptions
We make three simplifying assumptions, none of which affects our conclusions:
1. Entry and exit only The only long-run adjustment is the entry or exit of firms.
Moreover, we ignore all short-run adjustments to concentrate on the effects of the
long-run adjustments.
232 Part Two • Microeconomics of Product Markets

2. Identical costs All firms in the industry have identical cost curves. This assump-
tion lets us discuss an average, or representative, firm, knowing that all other firms
in the industry are similarly affected by any long-run adjustments that occur.
3. Constant-cost industry The industry is a constant-cost industry, which means
that the entry or exit of firms does not affect resource prices or, consequently, the
locations of the average-total-cost curves of individual firms.

The Goal of Our Analysis

The basic conclusion we want to explain is this: After all long-run adjustments are
completed, product price will be exactly equal to, and production will occur at, each
firm’s minimum average total cost.
This conclusion follows from two basic facts: (1) Firms seek profits and avoid
losses, and (2) under pure competition, firms are free to enter and leave an indus-
try. If market price initially exceeds average total costs, the resulting economic prof-
its will attract new firms to the industry, but this industry expansion will increase
supply until price is brought back down to equality with minimum average total
cost. Conversely, if price is initially less than average total cost, resulting losses will
cause firms to leave the industry. As they leave, total supply will decline, bringing
the price back up to equality with minimum average total cost.

Long-Run Equilibrium
Consider the average firm in a purely competitive industry that is initially in long-
run equilibrium. This firm is represented in Figure 9-8(a), where MR = MC and price
and minimum average total cost are equal at $50. Economic profit here is zero; the
industry is in equilibrium or at rest because there is no tendency for firms to enter
or to leave. The existing firms are earning normal profits, which, recall, are included
in their cost curves. The $50 market price is determined in Figure 9-8(b) by market

FIGURE 9-8 TEMPORARY PROFITS AND THE RE-ESTABLISHMENT

OF LONG-RUN EQUILIBRIUM IN A REPRESENTATIVE
FIRM (PANEL A) AND THE INDUSTRY (PANEL B)
A favourable shift in P P
demand (D1 to D2) will S1
upset the original MC
industry equilibrium
and produce eco- ATC
nomic profits. But
those profits will S2
cause new firms to $60 $60
enter the industry, 50 MR 50
increasing supply D2
40 40
(S1 to S2) and lower-
ing product price until
economic profits are
once again zero. D1

0 100 Q 0 90,000 100,000 110,000 Q

(a) Single firm (b) Industry
 chapter nine • pure competition 233

or industry demand D1 and supply S1. (S1 is a short-run supply curve; we will
develop the long-run industry supply curve in our discussion.)
As shown on the quantity axes of the two graphs, equilibrium output in the
industry is 100,000, while equilibrium output for the single firm is 100. If all firms
in the industry are identical, there must be 1000 firms (= 100,000/100).

ENTRY ELIMINATES ECONOMIC PROFITS

Let’s upset the long-run equilibrium in Figure 9-8 and see what happens. Suppose
a change in consumer tastes increases product demand from D1 to D2. Price will rise
to $60, as determined at the intersection of D2 and S1, and the firm’s marginal-
revenue curve will shift upward to $60. This $60 price exceeds the firm’s average
total cost of $50 at output 100, creating an economic profit of $10 per unit. This eco-
nomic profit will lure new firms into the industry. Some entrants will be newly cre-
ated firms; others will shift from less prosperous industries.
<economics.about.com/ As firms enter, the market supply of the product increases, pushing the product
money/economics/ price below $60. Economic profits persist, and entry continues until short-run sup-
library/weekly/ ply increases to S2. Market price falls to $50, as does marginal revenue for the firm.
aa010900.htm>
The great Pokémon
Price and minimum average total cost are again equal at $50. The economic profits
crash of 2000: Supply caused by the boost in demand have been eliminated, and, as a result, the previous
and demand for the incentive for more firms to enter the industry has disappeared. Long-run equilib-
grade school set rium has been restored.
Observe in Figure 9-8(a) and (b) that total quantity supplied is now 110,000 units
and each firm is producing 100 units. Now 1100 firms rather than the original 1000
populate the industry. Economic profits have attracted 100 more firms.

EXIT ELIMINATES LOSSES

Now let’s consider a shift in the opposite direction. We begin in Figure 9-9(b) with
curves S1 and D1 setting the same initial long-run equilibrium situation as in our
previous analysis, including the $50 price.

FIGURE 9-9 TEMPORARY LOSSES AND THE RE-ESTABLISHMENT

OF LONG-RUN EQUILIBRIUM IN A REPRESENTATIVE
FIRM (PANEL A) AND THE INDUSTRY (PANEL B)
An unfavourable shift P P
in demand (D1 to D3)
will upset the original S3
industry equilibrium MC
and produce losses,
but those losses will ATC
cause firms to leave S1
the industry, decreas- $60 $60
ing supply (S1 to S3) 50
50 MR
and increasing
product price until 40 40 D1
all losses have
disappeared.
D3

0 100 Q 0 90,000 100,000 Q

(a) Single firm (b) Industry
 234 Part Two • Microeconomics of Product Markets

Suppose consumer demand declines from D1 to D3. This decline forces the mar-
ket price and marginal revenue down to $40, making production unprofitable at the
minimum ATC of $50. In time the resulting losses will induce firms to leave the
industry. Their owners will seek a normal profit elsewhere rather than accept the
below-normal profits (loss) now confronting them. And as capital equipment wears
out, some firms will simply go out of business. As this exodus of firms proceeds,
however, industry supply decreases, pushing the price up from $40 toward $50.
Losses continue and more firms leave the industry until the supply curve shifts to
S3. Once this happens, price is again $50, just equal to the minimum average total
cost. Losses have been eliminated and long-run equilibrium is restored.
In Figure 9-9(a), total quantity supplied is now 90,000 units and each firm is pro-
ducing 100 units. Only 900 firms, not the original 1000, populate the industry.
Losses have forced 100 firms out.
You may have noted that we have sidestepped the question of which firms will
leave the industry when losses occur by assuming that all firms have identical cost
curves. In the real world, of course, entrepreneurial talents differ. Even if resource
prices and technology are the same for all firms, inferior entrepreneurs tend to incur
higher costs and, therefore, are the first to leave an industry when demand declines.
Similarly, firms with less productive labour forces will be higher-cost producers and
likely candidates to quit an industry when demand decreases.
We have now reached an intermediate goal: Our analysis verifies that competi-
tion, reflected in the entry and exit of firms, eliminates economic profits or losses by
adjusting price to equal minimum long-run average total cost. In addition, this com-
petition forces firms to select output levels at which average total cost is minimized.

long-run Long-Run Supply for a Constant-Cost Industry

supply
curve A curve Although our analysis has dealt with the long run, we have noted that the market
that shows the supply curves in Figures 9-8(b) and 9-9(b) are short-run curves. What then is the
prices at which a character of the long-run supply curve of a competitive industry? The analysis
purely competitive
industry will make
points us toward an answer. The crucial factor here is the effect, if any, that changes
various quantities in the number of firms in the industry will have on costs of the individual firms in
of the product avail- the industry.
able in the long run.
CONSTANT-COST INDUSTRY
constant-
cost In our analysis of long-run competitive equilibrium we assumed that the industry
industry An under discussion was a constant-cost industry, which means that industry expan-
industry in which sion or contraction will not affect resource prices or production costs. Graphically,
the entry of new it means that the entry or exit of firms does not shift the long-run ATC curves of
firms has no effect
on resource prices
individual firms. This is the case when the industry’s demand for resources is small
and thus no effect in relation to the total demand for those resources; the industry can expand or con-
on production costs. tract without significantly affecting resource prices and costs.

PERFECTLY ELASTIC LONG-RUN SUPPLY

What does the long-run supply curve of a constant-cost industry look like? The
answer is contained in our previous analysis. There we saw that the entry and exit
of firms changes industry output but always brings the product price back to its
<www.theshortrun.com/ original level, where it is just equal to the constant minimum ATC. Specifically, we
classroom/
glossary/macro/
discovered that the industry would supply 90,000, 100,000, or 110,000 units of out-
marketequilibrium.html> put, all at a price of $50 per unit. In other words, the long-run supply of a constant-
Market equilibrium cost industry is perfectly elastic.
 chapter nine • pure competition 235

This is demonstrated graphically in Figure 9-10, which uses data from Figures 9-8
and 9-9. Suppose industry demand is originally D1, industry output is Q1 (100,000
units), and product price is P1 ($50). This situation, from Figure 9-8, is one of long-
run equilibrium. We saw that when demand increases to D2, upsetting this equilib-
rium, the resulting economic profits attract new firms. Because this is a constant-cost
industry, entry continues and industry output expands until the price is driven back
down to the level of the unchanged minimum ATC, which is at price P2 ($50) and
output Q2 (110,000).
From Figure 9-9, we saw that a decline in market demand from D1 to D3 causes
an exit of firms and ultimately restores equilibrium at price P3 ($50) and output Q3
(90,000 units). The points Z1, Z2, and Z3 in Figure 9-10 represent these three
price–quantity combinations. A line or curve connecting all such points shows the
various price–quantity combinations that firms would produce if they had enough
time to make all desired adjustments to changes in demand. This line or curve is the
industry’s long-run supply curve. In a constant-cost industry this curve (straight
line) is horizontal, as in Figure 9-10, thus representing perfectly elastic supply.

Long-Run Supply for an Increasing-Cost Industry

increasing- Constant-cost industries are a special case. Most industries are increasing-cost
cost industries, in which firms’ ATC curves shift upward as the industry expands and
industry An downward as the industry contracts. Usually, the entry of new firms will increase
industry in which
the entry of new
resource prices, particularly so in industries using specialized resources whose sup-
firms raises the plies are not readily increased in response to an increase in resource demand. Higher
prices for resources resource prices result in higher long-run average total costs for all firms in the indus-
and thus increases try. These higher costs cause upward shifts in each firm’s long-run ATC curve.
their production Thus, when an increase in product demand results in economic profits and
costs.
attracts new firms to an increasing-cost industry, a two-way squeeze works to elim-
inate those profits. As before, the entry of new firms increases market supply and
lowers the market price, but now the entire ATC curve shifts upward. The overall
result is a higher-than-original equilibrium price. The industry produces a larger
output at a higher product price because the industry expansion has increased

FIGURE 9-10 THE LONG-RUN SUPPLY CURVE FOR A CONSTANT-

COST INDUSTRY IS HORIZONTAL
Because the entry or exodus of P
firms does not affect resource
prices or, therefore, unit costs,
an increase in demand (D1 to D2)
causes an expansion in industry
output (Q1 to Q2) but no alter-
ation in price ($50). Similarly, a P1
decrease in demand (D1 to D3) P2 = $50 S
causes a contraction of output Z3 Z1 Z2
P3
(Q1 to Q3) but no change in price.
D2
This means that the long-run D1
industry supply curve (S) is D3
horizontal through points Z1, Z2, 0 Q3 Q1 Q2 Q
and Z3.
90,000 100,000 110,000
236 Part Two • Microeconomics of Product Markets

resource prices and the minimum average total cost. We know that, in the long run,
the product price must cover ATC.
Since greater output will be supplied at a higher price, the long-run industry sup-
ply curve is upsloping. Instead of supplying 90,000, 100,000, or 110,000 units at the
same price of $50, an increasing-cost industry might supply 90,000 units at $45,
100,000 units at $50, and 110,000 units at $55. A higher price is required to induce
more production, because costs per unit of output increase as production rises.
We show this in Figure 9-11. Original market demand is D1 and industry price
and output are P1 ($50) and Q1 (100,000 units), respectively, at equilibrium point Y1.
An increase in demand to D2 upsets this equilibrium and leads to economic profits.
New firms enter the industry, increasing both market supply and production costs
of individual firms. A new price is established at point Y2, where P2 is $55 and Q2 is
110,000 units.
Conversely, a decline in demand from D1 to D3 makes production unprofitable
and causes firms to leave the industry. The resulting decline in resource prices
reduces the minimum average total cost of production for firms that stay. A new
equilibrium price is established at some level below the original price, say, at point
Y3, where P3 is $45 and Q3 is 90,000 units. Connecting these three equilibrium posi-
tions, we derive the upsloping long-run supply curve S in Figure 9-11.

Long-Run Supply for a Decreasing-Cost Industry

decreasing- In a decreasing-cost industry, a firm experiences lower costs as the industry expands.
cost The personal computer industry is an example. As demand for personal computers
industry An increased, new manufacturers of computers entered the industry and greatly
industry in which
the entry of firms
increased the resource demand for the components used to build them (for exam-
lowers the prices of ple, memory chips, hard drives, monitors, and operating software). The expanded
resources and thus production of those components enabled the producers of those items to achieve
decreases produc- substantial economies of scale. The decreased production costs of the components
tion costs. reduced their prices, which greatly lowered the computer manufacturers’ average
costs of production. The supply of personal computers increased by more than
demand, and the price of personal computers declined.

FIGURE 9-11 THE LONG-RUN SUPPLY CURVE FOR AN

INCREASING-COST INDUSTRY IS UPSLOPING
In an increasing-cost indus- P
try the entry of new firms in
response to an increase in
demand (D3 to D1 to D2) will
bid up resource prices and
thereby increase unit costs. S
As a result, an increased
P2 $55
industry output (Q3 to Q1 to Y2
Q2) will be forthcoming only P1 50
P3 45 Y1
at higher prices ($55 > $50 > D2
$45). The long-run industry Y3
D1
supply curve (S) therefore D3
slopes upward through
points Y3, Y1, and, Y2. 0 Q3 Q1 Q2 Q
90,000 100,000 110,000
 chapter nine • pure competition 237

We urge you to rework the analysis underlying Figure 9-11 to show that the long-
run supply curve of a decreasing-cost industry is downsloping. (Key Question 6)

Pure Competition and Efficiency

The
Our final goal in this chapter is to relate pure competition to efficiency. Whether a
Effectiveness purely competitive industry is a constant-cost industry or an increasing-cost indus-
of Markets
try, the final long-run equilibrium positions of all firms have the same basic charac-
teristics relating to economic efficiency. As shown in Figure 9-12 (Key Graph), price
(and marginal revenue) will settle where it is equal to minimum average total cost:
P (and MR) = minimum ATC. Since the marginal-cost curve intersects the average-
total-cost curve at its minimum point, marginal cost and average total cost are equal:
MC = minimum ATC. Thus, in long-run equilibrium a multiple equality exists: P
(and MR) = MC = minimum ATC.
This triple equality tells us that although a competitive firm may realize eco-
nomic profit or loss in the short run, it will earn only a normal profit by producing
in accordance with the MR (= P) = MC rule in the long run. Also, this triple equal-
ity suggests certain conclusions of great social significance concerning the effi-
ciency of a purely competitive economy.
Economists agree that, subject to qualifications discussed in later chapters, an
idealized purely competitive economy leads to an efficient use of society’s scarce
resources. A competitive market economy uses the limited amounts of resources
available to society in a way that maximizes the satisfaction of consumers. As we
demonstrated in Chapter 2, efficient use of limited resources requires both produc-
tive efficiency and allocative efficiency.
productive Productive efficiency requires that goods and services be produced in the least
efficiency costly way. Allocative efficiency requires that resources be apportioned among
The production of a firms and industries so as to yield the mix of products and services most wanted by
good or service in
the least costly way.
society (consumers). Allocative efficiency has been realized when it is impossible to
alter the composition of total output and achieve a net gain for society. Let’s look at
allocative how productive and allocative efficiency are achieved under purely competitive
efficiency conditions.
When resources are
apportioned among
firms and industries Productive Efficiency: P = Minimum ATC
to obtain the mix of
products and serv- In the long run, pure competition forces firms to produce at the minimum average
ices most wanted total cost of production and to charge a price that is just consistent with that cost, a
by society. highly favourable situation for the consumer. Unless firms use the best-available
(least-cost) production methods and combinations of inputs, they will not survive.
Stated differently, the minimum amount of resources will be used to produce any
particular output. Let’s suppose that output is cucumbers.
In the final equilibrium position shown in Figure 9-9(a), each firm in the cucum-
ber industry is producing 100 units (say, pickup truckloads) of output by using
$5000 (equal to average total cost of $50 × 100 units) worth of resources. If one firm
produced that same output at a total cost of, say, $7000, its resources would be used
inefficiently. Society would be faced with a net loss of $2000 worth of alternative
products. This loss cannot happen in pure competition; this firm’s loss of $2000
would require it either to reduce its costs or go out of business.
Note, too, that consumers benefit from productive efficiency by paying the low-
est product price possible under the prevailing technology and cost conditions.
238 Part Two • Microeconomics of Product Markets

Key Graph FIGURE 9-12 THE LONG-RUN EQUILIBRIUM POSITION

OF A COMPETITIVE FIRM: P = MC =
MINIMUM ATC

The equality of price and minimum

average total cost indicates that the MC
firm is using the most efficient
ATC
technology, is charging the lowest
price, P, and is producing the great-

Price
est output, Q, consistent with its
costs. The equality of price and mar-
ginal cost indicates that resources
are being allocated in accordance P MR
with consumer preferences.
P = MC = minimum ATC
(normal profit)
0 Q
Quantity

Quick Quiz
1. We know this firm is a price-taker because
a. its MC curve slopes upward.
b. its ATC curve is U-shaped.
c. its MR curve is horizontal.
d. MC and ATC are equal at the profit-maximizing output.

2. This firm’s MC curve is rising because

a. it is a price-taker.
b. of the law of diminishing marginal utility.
c. wage rates rise as output expands.
d. of the law of diminishing marginal returns.

3. At this firm’s profit-maximizing output

a. total revenue equals total cost.
b. it is earning an economic profit.
c. allocative, but not necessarily productive, efficiency is achieved.
d. productive, but not necessarily allocative, efficiency is achieved.

4. The equality of P, MC, and minimum ATC

a. occurs only in constant-cost industries.
b. encourages entry of new firms.
c. means that the right goods are being produced in the right ways.
d. results in a zero accounting profit.

Answers
1. c; 2. d; 3. a; 4. c
 chapter nine • pure competition 239

Allocative Efficiency: P = MC
Productive efficiency alone does not ensure the efficient allocation of resources.
Least-cost production must be used to provide society with the right goods—the
goods that consumers want most. Before we can show that the competitive market
system does just that, we must discuss the social meaning of product prices. There
are two critical elements here.
1. The money price of any product is society’s measure of the relative worth of an
additional unit of that product—for example, cucumbers. So, the price of a unit
of cucumbers is the marginal benefit derived from that unit of the product.
2. Similarly, recalling the idea of opportunity cost, we see that the marginal cost of
an additional unit of a product measures the value, or relative worth, of the other
goods sacrificed to obtain it. In producing cucumbers, resources are drawn away
from producing other goods. The marginal cost of producing a unit of cucumbers
measures society’s sacrifice of those other goods.
To understand why P = MC defines allocative efficiency, let’s first look at situations
where that is not the case.

UNDERALLOCATION: P > MC
In pure competition, a firm will realize the maximum possible profit only by pro-
ducing where price equals marginal cost (Figure 9-12). Producing fewer cucumbers
such that MR (and thus P) exceeds MC yields less than maximum profit. It also
entails, from society’s viewpoint, an underallocation of resources to this product.
The fact that price still exceeds marginal cost indicates that society values additional
units of cucumbers more highly than the alternative products the appropriate
resources could otherwise produce.
To illustrate, if the price or marginal benefit of a unit of cucumbers is $100 and its
marginal cost is $50, producing an additional unit will cause a net increase in total
well-being of $50. Society will gain cucumbers valued at $100, while the alternative
products sacrificed by allocating more resources to cucumbers would be valued at
only $50. Whenever society can gain something valued at $100 by giving up some-
thing valued at $50, the initial allocation of resources must have been inefficient.

OVERALLOCATION: P < MC
For similar reasons, the production of cucumbers should not go beyond the output
at which price equals marginal cost. To produce where MC exceeds MR (and thus
P) would yield less than the maximum profit for the producer and, from the view-
point of society, would entail an overallocation of resources to cucumbers. Produc-
ing cucumbers at the level where marginal cost exceeds price (or marginal benefit)
means that society is producing cucumbers by sacrificing alternative goods that
society values more highly.
For example, if the price of a unit of cucumbers is $75 and its marginal cost is
$100, then the production of one less unit of cucumbers would result in a net
increase in society’s total well-being of $25. Society would lose cucumbers valued
at $75, but reallocating the freed resources to their best alternative uses would
increase the output of some other good valued at $100. Whenever society is able to
give up something of lesser value in return for something of greater value, the orig-
inal allocation of resources must have been inefficient.
240 Part Two • Microeconomics of Product Markets

EFFICIENT ALLOCATION
Our conclusion must be that in pure competition, when profit-motivated firms produce
each good or service to the point where price (marginal benefit) and marginal cost are
equal, society’s resources are being allocated efficiently. Each item is being produced to
the point at which the value of the last unit is equal to the value of the alternative goods
sacrificed by its production. To alter the production of cucumbers would reduce con-
sumer satisfaction. To produce cucumbers beyond the P = MC point would sacrifice
alternative goods whose value to society exceeds that of the extra cucumbers. To pro-
duce cucumbers short of the P = MC point would sacrifice cucumbers that society val-
ues more than the alternative goods its resources could produce. (Key Question 7)

DYNAMIC ADJUSTMENTS
A further attribute of purely competitive markets is their ability to restore efficiency
when disrupted by changes in the economy. A change in consumer tastes, resource
supplies, or technology will automatically set in motion the appropriate realign-
ments of resources. For example, suppose that cucumbers and pickles become dra-
matically more popular. First, the price of cucumbers will increase so that, at current
output, the price of cucumbers will exceed its marginal cost. At this point efficiency
will be lost, but the higher price will create economic profits in the cucumber indus-
try and stimulate its expansion. The profitability of cucumbers will permit the
industry to bid resources away from now less pressing uses, say watermelons.
Expansion of the industry will end only when the price of cucumbers and its mar-
ginal cost are equal—that is, when allocative efficiency has been restored.
Similarly, a change in the supply of a particular resource—for example, the field
labourers who pick cucumbers—or in a production technique will upset an existing
price–marginal-cost equality by either raising or lowering marginal cost. The result-
ing inequality will cause business managers, when either pursuing profit or avoid-
ing loss, to reallocate resources until price once again equals marginal cost. In so
doing, they will correct any inefficiency in the allocation of resources that the orig-
inal change may have temporarily imposed on the economy.

THE INVISIBLE HAND REVISITED

Finally, the highly efficient allocation of resources that a purely competitive econ-
omy promotes comes about because businesses and resource suppliers seek to fur-
ther their self-interest. The invisible hand (Chapter 4) is at work in a competitive
market system. The competitive system not only maximizes profits for individual
producers but creates a pattern of resource allocation that maximizes consumer sat-
isfaction. The invisible hand thus organizes the private interests of producers in a
way that is fully in accord with society’s interest in using scarce resources efficiently.

● In the long run, the entry of firms into an indus-
try will compete away any economic profits,
and the exit of firms will eliminate losses so that
price and minimum average total cost are equal.
● The long-run supply curves of constant-cost,
increasing-cost, and decreasing-cost industries
are horizontal, upsloping, and downsloping,
respectively.
● In purely competitive markets both productive
efficiency (price equals minimum average total
cost) and allocative efficiency (price equals
marginal cost) are achieved in the long run.
 chapter nine • pure competition 241

PURE COMPETITION AND

CONSUMER SURPLUS
Pure competition provides consumers with the
largest utility surplus that is consistent with
keeping the product in production.
In almost all markets, con- There are many other con- A glance at the figure shows
sumers collectively obtain more sumers besides Bob, Barb, Bill, that the amount of consumer
utility (total satisfaction) from Bart, and Brent in this market surplus—the size of the blue tri-
their purchases than the amount who are willing to pay prices angle—would be less if the sell-
of their expenditures (product above $4. Only Betty pays ex- ers could charge some price
price × quantity). This surplus of actly the price she is willing to above $4. As just one exam-
utility arises because some con- pay; the others receive some ple, at a price of $8, only a very
sumers are willing to pay more amount of utility beyond their small triangle of consumer sur-
than the equilibrium price but expenditures. The difference be- plus would exist. But purely
need not do so. tween that utility value (meas- competitive firms cannot charge
Consider the market for or- ured by the vertical height of the $8 because they are price-takers.
anges depicted in the figure points on the demand curve) Any firm that charged a price
below. The demand curve D tells and the $4 price is called con- above $4 would immediately
us that some consumers of or- sumer surplus. When we add to- lose all its business to the other
anges are willing to pay more gether each buyer’s utility sur- firms.
than the $4 equilibrium price per plus, we obtain the consumer We know that in pure compe-
bag. For example, assume Bob is surplus for all the consumers in tition the equilibrium price
willing to pay $9; Barb, $8; Bill, the market. To get the Q1 bags of equals the marginal cost of the
$7; Bart, $6; and Brent, $5. Betty, oranges, consumers collectively Q1 bags of oranges. And, since
in contrast, is unwilling to pay are willing to pay the sum of we are assuming that entry and
one penny more than the $4 the amounts represented by the exit have resulted in this price
equilibrium price. blue triangle and grey rectangle. being equal to the lowest aver-
However, they only have to pay age total cost, each seller is
P the amount represented by the earning only a normal profit. By
grey rectangle. The blue trian- definition, this profit is just suffi-
$10
Consumer S (∑MC) gle thus represents consumer cient to continue production of
surplus surplus. oranges.
8
The principle that emerges is
6 this: By establishing the lowest
price consistent with continued
4 production, pure competition
yields the largest sustainable
2 amount of consumer surplus.
D (For a more detailed treatment
of consumer surplus, see Chap-
0 Q1 Q
ter 12.)
242 Part Two • Microeconomics of Product Markets

chapter summary
1. Economists group industries into four mod-
els based on their market structures: (a) pure
competition, (b) pure monopoly, (c) monop-
olistic competition, and (d) oligopoly.
2. A purely competitive industry consists of a
large number of independent firms produc-
ing a standardized product. Pure competi-
tion assumes that firms and resources are
mobile among different industries.
3. In a competitive industry, no single firm can
influence market price, which means that the
firm’s demand curve is perfectly elastic and
price equals marginal revenue.
4. We can analyze short-run profit maximization
by a competitive firm by comparing total rev-
enue and total cost or by applying marginal
analysis. A firm maximizes its short-run profit
by producing the output at which total revenue
exceeds total cost by the greatest amount.
5. Provided price exceeds minimum average
variable cost, a competitive firm maximizes
profit or minimizes loss in the short run by
producing the output at which price or mar-
ginal revenue equals marginal cost. If price
is less than average variable cost, the firm
minimizes its loss by shutting down. If price
is greater than average variable cost but is
less than average total cost, the firm mini-
mizes its loss by producing the P = MC out-
put. If price also exceeds average total cost,
the firm maximizes its economic profit at the
P = MC output.
6. Applying the MR (= P) = MC rule at various
possible market prices leads to the conclu-
sion that the segment of the firm’s short-run
marginal-cost curve that lies above the firm’s
average-variable-cost curve is its short-run
supply curve.
7. In the long run, the market price of a product
will equal the minimum average total cost of
production. At a higher price, economic prof-
its would cause firms to enter the industry
until those profits had been competed away.
At a lower price, losses would force the exit
of firms from the industry until the product
price rose to equal average total cost.
8. The long-run supply curve is horizontal for a
constant-cost industry, upsloping for an
increasing-cost industry, and downsloping
for a decreasing-cost industry.
9. The long-run equality of price and minimum
average total cost means that competitive
firms will use the most efficient technology
and charge the lowest price consistent with
their production costs.
10. The long-run equality of price and marginal
cost implies that resources will be allocated
in accordance with consumer tastes. The
competitive price system will reallocate
resources in response to a change in con-
sumer tastes, in technology, or in resource
supplies and will thereby to maintain alloca-
tive efficiency over time.

terms and concepts

pure competition, p. 214
pure monopoly, p. 214
monopolistic competition,
p. 214
oligopoly, p. 214
imperfect competition, p. 214
price-taker, p. 215
average revenue, p. 216
total revenue, p. 217
marginal revenue, p. 217
break-even point, p. 219
MR = MC rule, p. 221
short-run supply curve, p. 227
long-run supply curve, p. 234
constant-cost industry, p. 234
increasing-cost industry,
p. 235
decreasing-cost industry,
p. 236
productive efficiency, p. 237
allocative efficiency, p. 237

study questions
1. Briefly state the basic characteristics of pure
competition, pure monopoly, monopolistic
competition, and oligopoly. Under which of
these market classifications does each of the
following most accurately fit? (a) a supermar-
ket in your home town; (b) the steel industry;
(c) a Satskatchewan wheat farm; (d) the char-
tered bank in which you or your family has an
account; (e) the automobile industry. In each
case justify your classification.
 chapter nine • pure competition 243

2. Strictly speaking, pure competition has never it does produce, what will be the profit-
existed and probably never will. Then why maximizing or loss-minimizing output?
study it? Explain. What economic profit or loss will
3. KEY QUESTION Use the following the firm realize per unit of output?
demand schedule to determine total revenue b. Answer the questions in 4a assuming prod-
and marginal revenue for each possible level uct price is $41.
of sales: c. Answer the questions in 4a assuming prod-
uct price is $32.
Product Quantity Total Marginal
price demanded revenue revenue d. In the table below, complete the short-run
supply schedule for the firm (columns 1
$2 0 $______ and 2) and indicate the profit or loss
$______
2 1 ______ incurred at each output (column 3).
______
2 2 ______ (1) (2) (3) (4)
______
2 3 ______ Price Quantity Profit (+) Quantity
______ supplied, or loss (–) supplied,
2 4 ______
______ single firm 1500 firms
2 5 ______
$26 ______ $______ ______
a. What can you conclude about the struc-
32 ______ ______ ______
ture of the industry in which this firm is
operating? Explain. 38 ______ ______ ______

b. Graph the demand, total-revenue, and 41 ______ ______ ______

marginal-revenue curves for this firm. 46 ______ ______ ______
c. Do the demand and marginal-revenue 56 ______ ______ ______
curves coincide? If so, why? If not, why not? 66 ______ ______ ______
d. “Marginal revenue is the change in total
revenue associated with additional units e. Explain: “That segment of a competitive
of output.” Explain in words and graphi- firm’s marginal-cost curve that lies above
cally, using the data in the table. its average-variable-cost curve constitutes
the short-run supply curve for the firm.”
4. KEY QUESTION Assume the following Illustrate graphically.
cost data are for a purely competitive producer:
f. Now assume that there are 1500 identical
Average Average Average firms in this competitive industry; that is,
Total fixed variable total Marginal that there are 1500 firms, each of which has
product cost cost cost cost the cost data shown in the table. Complete
the industry supply schedule (column 4).
0
$45 g. Suppose the market demand data for the
1 $60.00 $45.00 $105.00 product are as follows:
40
2 30.00 42.50 72.50
35 Price Total quantity demanded
3 20.00 40.00 60.00
30
4 15.00 37.50 52.50 $26 17,000
35
5 12.00 37.00 49.00 32 15,000
40
6 10.00 37.50 47.50 38 13,500
45
7 8.57 38.57 47.14 41 12,000
55
8 7.50 40.63 48.13 46 10,500
65
9 6.67 43.33 50.00 56 9,500
75
10 6.00 46.50 52.50 66 8,000

a. At a product price of $56, will this firm pro- What will be the equilibrium price? What will
duce in the short run? Why or why not? If be the equilibrium output for the industry?
244 Part Two • Microeconomics of Product Markets
for each firm? What will profit or loss be per
unit? per firm? Will this industry expand or
contract in the long run?
5. Why is the equality of marginal revenue and
marginal cost essential for profit maximiza-
tion in all market structures? Explain why
price can be substituted for marginal revenue
in the MR = MC rule when an industry is
purely competitive.
6. KEY QUESTION Using diagrams for
both the industry and a representative firm,
illustrate competitive long-run equilibrium.
Assuming constant costs, employ these dia-
grams to show how (a) an increase and (b) a
decrease in market demand will upset that
long-run equilibrium. Trace graphically and
describe in words the adjustment processes
internet application questions
1. Suppose that you operate a purely compet-
itive firm that buys and sells foreign cur-
rencies. Also suppose that yesterday, your
business activity consisted of buying 100,000
Swiss francs at the market exchange rate
and selling them for a 3 percent commis-
sion. Go to the Bank of Canada’s website
<www.bankofcanada.ca> and select, in order,
Currency and Currency Converter. What was
your total revenue in Canadian dollars yester-
day? (Be sure to include your commission.)
Why would your profit for the day be consid-
erably less than this total revenue?
by which long-run equilibrium is restored.
Now rework your analysis for increasing-cost
and decreasing-cost industries and compare
the three long-run supply curves.
7. KEY QUESTION In long-run equilib-
rium, P = minimum ATC = MC. Of what signifi-
cance for economic efficiency is the equality of
P and minimum ATC? the equality of P and
MC? Distinguish between productive efficiency
and allocative efficiency in your answer.
8. (The Last Word) Suppose that improved tech-
nology causes the supply curve for oranges to
shift rightward in the market discussed in this
The Last Word (see the figure there). Assum-
ing the location of the demand curve does not
change, what will happen to consumer sur-
plus? Explain why.
2. In a purely competitive market, individual firms
produce homogeneous products and exert no
significant control over product price. The
Alberta government at <www.agric.gov.ab.ca/
economic/market/mpmod05.html> provides a
brief overview of how a commodity exchange
functions and has links to the main commod-
ity exchanges in North America. Visit the Win-
nipeg Commodity Exchange and select “Daily
Market Summary.” Which of the main crops
has had the largest price movement and why?

IN THIS CHAPTER
Y OU WILL LEARN:
The necessary conditions
required for monopoly to arise.
• telephone call, turn on your lights, or sub-
How the monopolist
determines the profit-
maximizing price and output.
•
About the economic effects
of monopoly.
•
Why a monopolist prefers
to charge different prices
in different markets.
TEN
Pure
Monopoly
e turn now from pure competition to
W pure monopoly, which is at the oppo-
site end of the spectrum of market
structures listed in Table 9-1. You deal with
monopolies—sole sellers of products and
services—more often than you might think.
When you see the logo for Microsoft’s Win-
dows on your computer, you are dealing with
a monopoly. When you purchase certain pre-
scription drugs, you may be buying monopo-
lized products. When you make a local
scribe to cable TV, you may be patronizing a
monopoly, depending on your location.
What precisely do we mean by pure
monopoly and what conditions enable it to
arise and survive? How does a pure monopo-
list determine its profit-maximizing price and
output quantity? Does a pure monopolist
achieve the efficiencies associated with pure
competition? If not, what should the govern-
ment do about it? A simplified model of pure
monopoly will help us answer these questions.
 246 Part Two • Microeconomics of Product Markets

Pure Mononpoly
pure Pure monopoly exists when a single firm is the sole producer of a product for
monopoly An which there are no close substitutes. Here are the main characteristics of pure
industry in which monopoly.
one firm is the sole
seller of a product ● Single seller A pure, or absolute, monopoly is an industry in which a single
or service. firm is the sole producer of a specific good or the sole supplier of a service; the
firm and the industry are synonymous.
● No close substitutes A pure monopoly’s product is unique in that there are
no close substitutes. The consumer who chooses not to buy the monopolized
product must do without it.
● Price-maker The pure monopolist controls the total quantity supplied and
thus has considerable control over price; it is a price-maker, unlike the pure
competitor that has no such control and, therefore, is a price-taker. The pure
monopolist confronts the usual downward-sloping product demand curve.
It can change its product price by changing the quantity of the product it
supplies. The monopolist will use this power whenever it is advantageous
to do so.
● Blocked entry A pure monopolist has no immediate competitors because cer-
tain barriers keep potential competitors from entering the industry. Those bar-
riers may be economic, technological, legal, or of some other type, but entry is
totally blocked in pure monopoly.

Examples of Monopoly
Examples of pure monopoly are relatively rare, but there are many examples of less
pure forms. In most cities, government-owned or government-regulated public
utilities—natural gas and electric companies, the water company, the cable TV com-
pany, and the local telephone company—may be monopolies or virtually so.
Professional sports teams are, in a sense, monopolies because they are the
sole suppliers of specific services in large geographic areas. With a few exceptions,
a single major-league team in each sport serves each large Canadian city. If you
want to see a live major-league baseball game in Toronto or Montreal, you must
patronize the Blue Jays or the Expos, respectively. Other geographic monopolies
exist. For example, a small town may be served by only one airline or railroad. In a
small, isolated community, the local bank, movie theatre, or bookstore may approx-
imate a monopoly.
<money.york.pa.us/ Of course, some competition almost always exists. Satellite television is a substi-
Articles/Microsoft.htm>
Predatory Pricing:
tute for cable, and amateur softball is a substitute for professional baseball. The
Microsoft’s Modus Linux operating system can substitute for Windows. But such substitutes are typi-
Operandi cally either more costly or in some way less appealing.

Dual Objectives of the Study of Monopoly

We want to examine pure monopoly not only for its own sake but also because such
a study will help you understand the more common market structures of monopo-
listic competition and oligopoly, to be discussed in Chapter 11. These two market
structures combine, in differing degrees, characteristics of pure competition and
pure monopoly.
 chapter ten • pure monopoly 247

Barriers to Entry
barriers The factors that prohibit firms from entering an industry are called barriers to entry.
to entry In pure monopoly, strong barriers to entry effectively block all potential competi-
Anything that artifi- tion. Somewhat weaker barriers may permit oligopoly, a market structure domi-
cially prevents the
entry of firms into
nated by a few firms. Still weaker barriers may permit the entry of a fairly large
an industry. number of competing firms, giving rise to monopolistic competition. The absence of
any effective entry barriers permits the entry of a very large number of firms, which
provide the basis of pure competition. So, barriers to entry are pertinent not only to
the extreme case of pure monopoly but also to other market structures in which
there is some degree of monopoly-like conditions and behaviour.

Economies of Scale
Modern technology in some industries is such that economies of scale—declining
average total cost with added firm size—are extensive. So, a firm’s long-run average-
cost schedule will decline over a wide range of output. Given market demand, only
a few large firms, or in the extreme, only a single large firm, can achieve low aver-
age total costs.
Figure 10-1 indicates economies of scale over a wide range of outputs. If total con-
sumer demand is within that output range, then only a single producer can satisfy
demand at least cost. Note, for example, that a monopolist can produce 200 units at
a per-unit cost of $10 and a total cost of $2000. If there are two firms in the industry
and each produces 100 units, the unit cost is $15 and total cost rises to $3000 (= 200
units × $15). A still more competitive situation with four firms each producing 50
units would boost unit and total cost to $20 and $4000, respectively. Conclusion:
When long-run ATC is declining, only a single producer, a monopolist, can produce
any particular output at minimum total cost.
If a pure monopoly exists in such an industry, economies of scale will serve as an
entry barrier and will protect the monopolist from competition. New firms that try
to enter the industry as small-scale producers cannot realize the cost economies of

FIGURE 10-1 ECONOMIES OF SCALE: THE NATURAL MONOPOLY CASE

A declining long-run
average-total-cost
curve over a wide $20
range of output quan-
Average total cost

tities indicates exten-

sive economies of 15
scale. A single
monopoly firm can
produce, say, 200 10
units of output at ATC
lower cost ($10 each)
than could two or
more firms that had a
combined output of
200 units. 0 50 100 200
Quantity
248 Part Two • Microeconomics of Product Markets

the monopolist and therefore cannot obtain the normal profits necessary for survival
or growth. A new firm might try to start out big, that is, to enter the industry as a
large-scale producer so as to achieve the necessary economies of scale, but the mas-
sive plant facilities required would necessitate huge amounts of financing, which a
new and untried enterprise would find difficult to secure. In most cases the finan-
cial obstacles and risks to starting big are prohibitive, which explains why efforts to
enter such industries as automobiles, computer operating software, commercial air-
craft, and basic steel are rarely successful.
In the extreme circumstance, in which the market demand curve cuts the long-
run ATC curve where average total costs are still declining, the single firm is called
a natural monopoly. It might seem that a natural monopolist’s lower unit cost would
enable it to charge a lower price than if the industry were more competitive. But that
won’t necessarily happen. A pure monopolist may, instead, set its price far above
ATC and obtain substantial economic profit. In that event, the lowest-unit-cost
advantage of a natural monopolist would accrue to the monopolist as profit and not
as lower prices to consumers, which is why the government regulates some natural
monopolies, specifying the price they may charge. We will say more about that later.

Legal Barriers to Entry: Patents and Licences

Government also creates legal barriers to entry by awarding patents and licences.

PATENTS
A patent is the exclusive right of an inventor to use, or to allow another to use, her
or his invention. Patents and patent laws aim to protect the inventor from rivals who
would use the invention without having shared in the effort and expense of devel-
<www.aamc.org/ oping it. At the same time, patents provide the inventor with a monopoly position
newsroom/reporter/ for the life of the patent. The world’s nations have agreed on a uniform patent
feb2000/gene.htm>
Does the gene
length of 17 years from the time of application. Patents have figured prominently in
patenting stampede the growth of modern-day giants such as IBM, Microsoft, Kodak, Xerox, Polaroid,
threaten science? General Electric, and Nortel.
Research and development (R&D) is what leads to most patentable inventions
and products. Firms that gain monopoly power through their own research or by
purchasing the patents of others can use patents to strengthen their market position.
The profit from one patent can finance the research required to develop new
patentable products. In the pharmaceutical industry, patents on prescription drugs
have produced large monopoly profits that have helped finance the discovery of
new patentable medicines. So, monopoly power achieved through patents may well
be self-sustaining, even though patents eventually expire and generic drugs then
compete with the original brand.

LICENCES
Government may also limit entry into an industry or occupation through licensing.
At the national level, the Canadian Radio-Television Telecommunications Commis-
sion licenses only so many radio and television stations in each geographic area. In
many large cities one of a limited number of municipal licences is required to drive
a taxicab. The consequent restriction of the supply of cabs creates economic profit
for cab owners and drivers. New cabs cannot enter the industry to force prices and
profit lower. In a few instances the government might license itself to provide some
product and thereby create a public monopoly. For example, in some provinces,
 chapter ten • pure monopoly 249

only province-owned retail outlets can sell liquor. Similarly, many provinces have
licensed themselves to run lotteries.

Ownership or Control of Essential Resources

A monopolist can use private property as an obstacle to potential rivals. For exam-
ple, a firm that owns or controls a resource essential to the production process can
prohibit the entry of rival firms. At one time the International Nickel Company of
Canada (now called Inco) controlled 90 percent of the world’s known nickel
reserves. A municipal sand and gravel firm may own all the nearby deposits of sand
and gravel. And, it is very difficult for new sports leagues to be created because
existing professional sports leagues have contracts with the best players and have
long-term leases on the major stadiums and arenas.

Pricing and Other Strategic Barriers to Entry

Even if a firm is not protected from entry by, say, extensive economies of scale or own-
ership of essential resources, entry may effectively be blocked by the way the monop-
olist responds to attempts by rivals to enter the industry. Confronted with a new
entrant, the monopolist may create an entry barrier by slashing its price, stepping up
its advertising, or taking other strategic action to make it difficult for the entrant to
succeed. In 2000 an American federal court ruled that Microsoft had engaged in ille-
gal actions to attempt to drive Netscape from the Internet browser market. Microsoft
developed its own browser, Internet Explorer, and gave it away free. It also provided
price discounts on its Windows operating system to computer manufacturers that
featured Microsoft’s Internet Explorer rather than Netscape’s Navigator.

Monopoly Demand
Now that we have explained the sources of monopoly, we want to build a model of
pure monopoly so that we can analyze its price and output decisions. Let’s start by
making three assumptions:
1. Patents, economies of scale, or resource ownership secure our monopolist’s
status.
2. No unit of government regulates the firm.
3. The firm is a single-price monopolist; it charges the same price for all units of
output.
The crucial difference between a pure monopolist and a purely competitive seller
lies on the demand side of the market. The purely competitive seller faces a perfectly
elastic demand at the price determined by market supply and demand. It is a price-
taker that can sell as much or as little as it wants at the going market price. Each
additional unit sold will add the amount of the constant product price to the firm’s
total revenue, which means that marginal revenue for the competitive seller is con-
stant and equal to product price. (Refer to Table 9-2 and Figure 9-1 for price, mar-
ginal-revenue, and total-revenue relationships for the purely competitive firm.)
The demand curve for the monopolist (and for any imperfectly competitive
seller) is very different from that of the pure competitor. Because the pure monop-
olist is the industry, its demand curve is the market demand curve. And because mar-
ket demand is not perfectly elastic, the monopolist’s demand curve is downsloping.
250 Part Two • Microeconomics of Product Markets

Columns 1 and 2 in Table 10-1 illustrate this concept. Note that quantity demanded
increases as price decreases.
In Chapter 9 we drew separate demand curves for the purely competitive indus-
try and for a single firm in such an industry, but only a single demand curve is
needed in pure monopoly. The firm and the industry are one and the same. We have
graphed part of the demand data in Table 10-1 as demand curve D in Figure 10-2.
This is the monopolist’s demand curve and the market demand curve. The
downward-sloping demand curve has three implications that are essential to under-
standing the monopoly model.

One: Marginal Revenue Is Less than Price

The monopolist’s downward-sloping demand curve means that it can increase sales
only by charging a lower price. Consequently marginal revenue is less than price
(average revenue) for every level of output except the first. Why? The reason is that
the lower price applies not only to the extra output sold but also to all prior units of
output. The monopolist could have sold these prior units at a higher price if the
extra output had not been produced and sold. Each additional unit of output sold
increases total revenue by an amount equal to its own price less the sum of the price
cuts that apply to all prior units of output.
Figure 10-2 confirms this point. We have highlighted two price–quantity combi-
nations from the monopolist’s demand curve. The monopolist can sell one more unit
at $132 than it can at $142 and that way obtain $132 of extra revenue. But to sell that
fourth unit for $132, the monopolist must also sell the first three units at $132 rather
than $142. This $10 reduction in revenue on three units results in a $30 revenue loss.
The net difference in total revenue from selling a fourth unit is $102: the $132 gain
minus the $30 loss. This net gain of $102—the marginal revenue of the fourth unit—
is obviously less than the $132 price of the fourth unit.

TABLE 10-1 REVENUE AND COST DATA OF A PURE MONOPOLIST

REVENUE DATA COST DATA
(1) (2) (3) (4) (5) (6) (7) (8)
Quantity Price Total Marginal Average Total cost Marginal Profit (+) or
of output (average revenue revenue total cost (1) × (5) cost loss (–)
revenue) (1) × (2)

0 $172 $ 0 $ 100 $–100

$162 $ 90
1 162 162 $190.00 190 – 28
142 80
2 152 304 135.00 270 + 34
122 70
3 142 426 113.33 340 + 86
102 60
4 132 528 100.00 400 +128
82 70
5 122 610 94.00 470 +140
62 80
6 112 672 91.67 550 +122
42 90
7 102 714 91.43 640 + 74
22 110
8 92 736 93.75 750 – 14
2 130
9 82 738 97.78 880 –142
–18 150
10 72 720 103.00 1030 –310
 chapter ten • pure monopoly 251

FIGURE 10-2 PRICE AND MARGINAL REVENUE IN PURE MONOPOLY

A pure monopolist, or any other P
imperfect competitor with a
downsloping demand curve $142, three units
such as D, must set a lower $142 $132, four
Loss = $30 units
price to sell more output. Here, 132
by charging $132 rather than
$142, the monopolist sells an
extra unit (the fourth unit) and D
gains $132 from that sale. But
from this gain must be sub-
tracted $30, which reflects Gain = $132
the $10 less the monopolist
charged for each of the first 3
units. Thus, the marginal rev-
enue of the fourth unit is $102
(= $132 – $30), considerably
less than its $132 price. 0 1 2 3 4 5 6 Q

Column 4 in Table 10-1 shows that marginal revenue is always less than the cor-
responding product price in column 2, except for the first unit of output. Because
marginal revenue is the change in total revenue associated with each additional unit
of output, the declining amounts of marginal revenue in column 4 mean that total
revenue increases at a diminishing rate (as shown in column 3).
We show the relationship between the monopolist’s marginal-revenue curve and
total-revenue curve in Figure 10-3. For this figure, we extended the demand and rev-
enue data of columns 1 through 4 in Table 10-1, assuming that successive $10 price
cuts each elicit one additional unit of sales. That is, the monopolist can sell 11 units
at $62, 12 units at $52, and so on.
Note that the monopolist’s MR curve lies below the demand curve, indicating
that marginal revenue is less than price at every output quantity but the very first
unit. Observe also the special relationship between total revenue and marginal rev-
enue. Because marginal revenue is the change in total revenue, marginal revenue is
positive while total revenue is increasing. When total revenue reaches its maximum,
marginal revenue is zero. When total revenue is diminishing, marginal revenue is
negative.

Two: The Monopolist Is a Price-Maker

All imperfect competitors, whether pure monopoly, oligopoly, or monopolistic com-
petition, face downward-sloping demand curves. So, firms in those industries can
to one degree or another influence total supply through their own output decisions.
In changing market supply, they can also influence product price. Firms with down-
ward-sloping demand curves are price-makers.
This fact is most evident in pure monopoly, where one firm controls total output.
The monopolist faces a downsloping demand curve in which each output is associ-
ated with some unique price. Thus, in deciding what volume of output to produce,
the monopolist is also indirectly determining the price it will charge. Through con-
trol of output, it can make the price. From columns 1 and 2 in Table 10-1 we find that
the monopolist can charge a price of $72 if it produces and offers for sale 10 units, a
price of $82 if it produces and offers for sale nine units, and so forth.
252 Part Two • Microeconomics of Product Markets

FIGURE 10-3 DEMAND, MARGINAL REVENUE, AND TOTAL

REVENUE FOR AN IMPERFECTLY COMPETITIVE FIRM
Panel (a): Because $200 Elastic Inelastic
an imperfectly com-
petitive firm must
lower its price on all
units sold in order to 150
increase its sales, the
marginal-revenue

Price
curve (MR) lies below 100
its downsloping
demand curve (D).
The elastic and
inelastic regions of 50 MR
demand are high- D
lighted. Panel (b):
Total revenue (TR)
increases at a 0 2 4 6 8 10 12 14 16 18 Q
decreasing rate,
reaches maximum,
(a) Demand and marginal-revenue curves
and then declines.
Note that in the elas-
tic region, TR is Elastic Inelastic
increasing and hence
MR is positive. When $750
TR reaches its maxi-
mum, MR is zero. In
the inelastic region
of demand, TR is
Total revenue

declining, so MR is 500
negative.
TR

250

0 2 4 6 8 10 12 14 16 18 Q

(b) Total-revenue curve

Three: The Monopolist Sets Prices in the Elastic Region of Demand

The total-revenue test for price elasticity of demand is the basis for our third impli-
cation. Recall from Chapter 6 that the total-revenue test reveals that when demand
is elastic, a decline in price will increase total revenue. Similarly, when demand is
inelastic, a decline in price will reduce total revenue. Beginning at the top of demand
curve D in Figure 10-3(a), observe that as the price declines from $172 to approxi-
mately $82, total revenue increases (and marginal revenue, therefore, is positive),
which means that demand is elastic in this price range. Conversely, for price
declines below $82, total revenue decreases (marginal revenue is negative), which
indicates that demand is inelastic there.
 chapter ten • pure monopoly 253

The implication is that a monopolist will never choose a price–quantity combi-

nation in which price reductions cause total revenue to decrease (marginal revenue
to be negative). The profit-maximizing monopolist will always want to avoid the
inelastic segment of its demand curve in favour of some price–quantity combination
in the elastic region. Here’s why: to get into the inelastic region, the monopolist
must lower price and increase output. In the inelastic region a lower price means
less total revenue. And increased output always means increased total cost. Less
total revenue and higher total cost yield lower profit. (Key Question 4)

● A pure monopolist is the sole supplier of a
product or service for which there are no close
substitutes.
● A monopoly survives because of entry barri-
ers such as economies of scale, patents and
licences, the ownership of essential resources,
and strategic actions to exclude rivals.
● The monopolist’s demand curve is downslop-
ing, and its marginal-revenue curve lies below
its demand curve.
● The downsloping demand curve means that the
monopolist is a price-maker.
● The monopolist will operate in the elastic
region of demand since it can increase total rev-
enue and reduce total cost by reducing output.

Output and Price Determination

At what specific price–quantity combination will a profit-maximizing monopolist choose
to operate? To answer this question, we must add production costs to our analysis.

Cost Data
On the cost side, we will assume that, although the firm is a monopolist in the prod-
<hadm.sph.sc.edu/ uct market, it hires resources competitively and employs the same technology as
Courses/Econ/ Chapter 9’s competitive firm. This assumption lets us use the cost data we devel-
Monopoly/Mon.html>
Economics interactive
oped in Chapter 8 and applied in Chapter 9, so we can compare the price–output
tutorial: Monopoly decisions of a pure monopoly with those of a pure competitor. Columns 5 through
price and output 7 in Table 10-1 reproduce the pertinent cost data from Table 8-2.

MR = MC Rule
A monopolist seeking to maximize total profit will employ the same rationale as a
profit-seeking firm in a competitive industry. It will produce another unit of output
as long as that unit adds more to total revenue than it adds to total cost. The firm
will increase output up to the output at which marginal revenue equals marginal
cost (MR = MC).
A comparison of columns 4 and 7 in Table 10-1 indicates that the profit-maxi-
mizing output is five units, because the fifth unit is the last unit of output whose
marginal revenue exceeds its marginal cost. What price will the monopolist charge?
The demand schedule shown as columns 1 and 2 in Table 10-1 indicates there is only
one price at which five units can be sold: $122.
This analysis is shown in Figure 10-4 (Key Graph), where we have graphed the
demand, marginal-revenue, average-total-cost, and marginal-cost data of Table 10-1.
254 Part Two • Microeconomics of Product Markets

Key Graph FIGURE 10-4 THE PROFIT-MAXIMIZING POSITION OF

A PURE MONOPOLIST
The pure monopolist maximizes $200
profit by producing the MR =
MC output, here Qm = 5 units. 175
Then, as seen from the demand
curve, it will charge price Pm = MC
$122. Average total cost will be 150

Price, costs, and revenue

A = $94, meaning that per-unit Profit
Pm = $122 per unit
profit is Pm – A and total profit 125
is 5 × (Pm – A). Total economic Economic
profit is thus represented by profit
100 ATC
the grey rectangle.

75 A = $94 D

50 MR = MC

25
Qm = 5 units MR

0 1 2 3 4 5 6 7 8 9 10 Q
Quantity

Quick Quiz
1. The MR curve lies below the demand curve in this figure because the
a. the demand curve is linear (a straight line).
b. the demand curve is highly inelastic throughout its full length.
c. the demand curve is highly elastic throughout its full length.
d. the gain in revenue from an extra unit of output is less than the price charged
for that unit of output.
2. The area labelled “Economic profit” can be found by multiplying the dif-
ference between P and ATC by quantity. It also can be found by
a. dividing profit per unit by quantity.
b. subtracting total cost from total revenue.
c. multiplying the coefficient of demand elasticity by quantity.
d. multiplying the difference between P and MC by quantity.
3. This pure monopolist
a. charges the highest price it can get.
b. earns only a normal profit in the long run.
c. restricts output to create an insurmountable entry barrier.
d. restricts output to increase its price and total economic profit.
4. At this monopolist’s profit-maximizing output
a. price equals marginal revenue.
b. price equals marginal cost.
c. price exceeds marginal cost.
d. profit per unit is maximized.
Answers
1. d; 2. b; 3. d; 4. c
 chapter ten • pure monopoly 255

The profit-maximizing output occurs at five units of output (Qm) where the mar-
ginal-revenue (MR) and marginal-cost (MC) curves intersect (MR = MC).
To find the price the monopolist will charge, we extend a vertical line from Qm up
to the demand curve D. The unique price Pm at which Qm units can be sold is $122,
which is in this case the profit-maximizing price. The monopolist sets the quantity
at Qm to charge its profit-maximizing price of $122.
In columns 2 and 5 in Table 10-1 we see that, at five units of output, the product
price ($122) exceeds the average total cost ($94). The monopolist thus earns an eco-
nomic profit of $28 per unit and the total economic profit is then $140 (= 5 units ×
$28). In Figure 10-4, per-unit profit is Pm – A where A is the average total cost of pro-
ducing Qm units. We find total economic profit by multiplying this per-unit profit by
the profit-maximizing output Qm.
Another way we can determine the profit-maximizing output is by comparing
total revenue and total cost at each possible level of production and choosing the
output with the greatest positive difference. Use columns 3 and 6 in Table 10-1 to
verify our conclusion that five units is the profit-maximizing output. An accurate
graphing of total revenue and total cost against output would also show the great-
est difference (the maximum profit) at five units of output. Table 10-2 is a step-by-
step summary of the process for determining the profit-maximizing output, the
profit-maximizing price, and economic profit in pure monopoly. (Key Question 5)

No Monopoly Supply Curve

Recall that MR equals P in pure competition and that the supply curve of a purely
competitive firm is determined by applying the MR (= P) = MC profit-maximizing
rule. At any specific market-determined price, the purely competitive seller will
maximize profit by supplying the quantity at which MC is equal to that price. When
the market price increases or decreases, the competitive firm produces more or less
output. Each market price is thus associated with a specific output, and all
price–output pairs together define the supply curve. This supply curve turns out to
be the portion of the firm’s MC curve that lies above the average-variable-cost curve
(see Figure 9-6).

TABLE 10-2 STEPS FOR GRAPHICALLY DETERMINING THE

PROFIT-MAXIMIZING OUTPUT, THE PROFIT-
MAXIMIZING PRICE, AND ECONOMIC PROFIT
(IF ANY) IN PURE MONOPOLY
Step 1. Determine the profit-maximizing output by finding where MR = MC.
Step 2. Determine the profit-maximizing price by extending a vertical line upward from the output
determined in step 1 to the pure monopolist’s demand curve.
Step 3. Determine the pure monopolist’s economic profit using one of two methods.
Method 1. Find profit per unit by subtracting the average total cost of the profit-maximizing
output from the profit-maximizing price. Then multiply the difference by the
profit-maximizing output to determine economic profit (if any).
Method 2. Find total cost by multiplying the average total cost of the profit-maximizing
output by that output. Find total revenue by multiplying the profit-maximizing
output by the profit-maximizing price. Then subtract total cost from total revenue
to determine economic profit (if any).
256 Part Two • Microeconomics of Product Markets

At first glance we would suspect that the pure monopolist’s marginal-cost curve
would also be its supply curve, but that is not the case. The pure monopolist has no sup-
ply curve; there is no unique relationship between price and quantity supplied for a
monopolist. Like the competitive firm, the monopolist equates marginal revenue
and marginal cost to determine output, but for the monopolist marginal revenue is
less than price. Because the monopolist does not equate marginal cost to price, it is
possible for different demand conditions to bring about different prices for the same
output. To convince yourself of this, refer to Figure 10-4 and pencil in a new, steeper
marginal-revenue curve that intersects the marginal-cost curve at the same point as
does the present marginal-revenue curve. Then draw in a new demand curve that
roughly corresponds with your new marginal-revenue curve. With the new curves,
the same MR = MC output of five units now corresponds with a higher profit-
maximizing price. Conclusion: There is no single, unique price associated with each
output level Qm, and so there is no supply curve for the pure monopolist.

Misconceptions Concerning Monopoly Pricing

Our analysis exposes two fallacies concerning monopoly behaviour.

NOT THE HIGHEST PRICE

Because a monopolist can manipulate output and price, people often believe it will
charge the highest price it can get. That is incorrect. There are many prices above Pm
in Figure 10-4, but the monopolist shuns them because they yield a smaller-than-
maximum total profit. The monopolist seeks maximum total profit, not maximum
price. Some high prices that could be charged would reduce sales and total revenue
too severely to offset any decrease in total cost.

TOTAL, NOT UNIT, PROFIT

The monopolist seeks maximum total profit, not maximum unit profit. In Figure
10-4 a careful comparison of the vertical distance between average total cost and
price at various possible outputs indicates that per-unit profit is greater at a point
slightly to the left of the profit-maximizing output Qm, as seen in Table 10-1, where
unit profit at four units of output is $32 (= $132 – $100) compared with $28 (= $122
– $94) at the profit-maximizing output of five units. Here the monopolist accepts a
lower-than-maximum per-unit profit because additional sales more than compen-
sate for the lower unit profit. A profit-seeking monopolist would rather sell five
units at a profit of $28 per unit (for a total profit of $140) than four units at a profit
of $32 per unit (for a total profit of only $128).

Possibility of Losses by Monopolist

The likelihood of economic profit is greater for a pure monopolist than for a pure
competitor. In the long run the pure competitor is destined to have only a normal
profit, whereas barriers to entry mean that any economic profit realized by the
monopolist can persist. In pure monopoly there are no entrants to increase supply,
drive down price, and eliminate economic profit.
But pure monopoly does not guarantee profit. The monopolist is not immune
to changes in tastes that reduce the demand for its product. Nor is it immune to
upward-shifting cost curves caused by escalating resource prices. If the demand and
cost situation faced by the monopolist is far less favourable than that in Figure
10-4, the monopolist will incur losses in the short run. Despite its dominance in the
 chapter ten • pure monopoly 257

market, the monopoly enterprise in Figure 10-5 suffers a loss, as shown, because of
weak demand and relatively high costs. Yet it continues to operate for the time being
because its total loss is less than its fixed cost. More precisely, at output Qm the
monopolist’s price Pm exceeds its average variable cost V. Its loss per unit is A – Pm,
and the total loss is shown by the pink rectangle.
Like the pure competitor, the monopolist will not persist in operating at a loss.
Faced with continuing losses, in the long run the firm’s owners will move their
resources to alternative industries that offer better profit opportunities. Thus, we
can expect the monopolist to realize a normal profit or better in the long run.

Economic Effects of Monopoly

Let’s now evaluate pure monopoly from the standpoint of society as a whole. Our
reference for this evaluation will be the outcome of long-run efficiency in a purely
competitive market, identified by the triple equality P = MC = minimum ATC.

Price, Output, and Efficiency

Figure 10-6 graphically contrasts the price, output, and efficiency outcomes of pure
monopoly and a purely competitive industry. Starting with Figure 10-6(a), we are
reminded that the purely competitive industry’s market supply curve S is the hor-
izontal sum of the marginal-cost curves of all the firms in the industry. Let’s suppose
there are 1000 such firms. Comparing their combined supply curves S with market
demand D, we get the purely competitive price and output of Pc and Qc.
Recall that this price–output combination results in both productive efficiency
and allocative efficiency. Productive efficiency is achieved because free entry and exit
forces firms to operate where average total cost is at a minimum. The sum of the
minimum-ATC outputs of the 1000 pure competitors is the industry output; here,
Qc. Product price is at the lowest level consistent with minimum average total cost.
The allocative efficiency of pure competition results because production occurs up to
that output at which price (the measure of a product’s value or marginal benefit to

FIGURE 10-5 THE LOSS-MINIMIZING POSITION OF A PURE

MONOPOLIST
If demand D is weak and
Price, costs, and revenue (dollars)

costs are high, the pure MC

monopolist may be unable
to make a profit. Because Pm Loss
exceeds V, the average vari- per unit
able cost at the MR = MC A ATC
output Qm, the monopolist Pm Loss AVC
will minimize losses in the
short run by producing at
that output. The loss per V
unit is A – Pm, and the total
loss is indicated by the pink MR = MC
rectangle. MR D
0 Qm
Quantity
258 Part Two • Microeconomics of Product Markets

FIGURE 10-6 INEFFICIENCY OF PURE MONOPOLY RELATIVE TO A

PURELY COMPETITIVE INDUSTRY
P P

S = MC MC
Pm
P = MC =
Pc minimum ATC Pc
MR = MC

D D
MR
0 Qc Q 0 Q m Qc Q

(a) Purely competitive industry (b) Pure monopoly

Panel (a): In a purely competitive industry, entry and exit of firms ensures that price (Pc) equals marginal cost (MC) and that
the minimum average-total-cost output (Qc) is produced. Both productive efficiency (P = minimum ATC) and allocative effi-
ciency (P = MC) are obtained. Panel (b): In pure monopoly, the MR curve lies below the demand curve. The monopolist maxi-
mizes profit at output Qm, where MR = MC, and charges price Pm. Thus, output is lower (Qm rather than Qc) and price is higher
(Pm rather than Pc) than they would be in a purely competitive industry. Monopoly is inefficient, since output is less than that
required for achieving minimum ATC (here at Qc) and because the monopolist’s price exceeds MC.

society) equals marginal cost (the worth of the alternative products forgone by soci-
ety in producing any given commodity). In short: P = MC = minimum ATC.
Now let’s suppose that this industry becomes a pure monopoly [Figure 10-6(b)]
as a result of one firm buying out all its competitors. We also assume that no
changes in costs or market demand result from this dramatic change in the indus-
try structure. What were formerly 1000 competing firms are now a single pure
monopolist consisting of 1000 noncompeting branches.
The competitive market supply curve S has become the marginal-cost curve (MC)
of the monopolist, the summation of the MC curves of its many branch plants.
(Since the monopolist does not have a supply curve, as such, we have removed the
S label.) The important change, however, is on the demand side. From the viewpoint
of each of the 1000 individual competitive firms, demand was perfectly elastic, and
marginal revenue was therefore equal to price. Each firm equated MR (= price) and
MC in maximizing profits. But market demand and individual demand are the same
to the pure monopolist. The firm is the industry, and thus the monopolist sees the
downsloping demand curve D shown in Figure 10-6(b).
This means that marginal revenue is less than price, and that graphically the MR
curve lies below demand curve D. In using the MR = MC rule, the monopolist
selects output Qm and price Pm. A comparison of both graphs in Figure 10-6 reveals
that the monopolist finds it profitable to sell a smaller output at a higher price than
do the competitive producers. Monopoly yields neither productive nor allocative
efficiency. The monopolist’s output is less than Qc, the output at which average total
cost is lowest. Price is higher than the competitive price Pc, which in long-run equi-
librium means pure competition equals minimum average total cost. Thus, the
 chapter ten • pure monopoly 259

monopoly price exceeds minimum average total cost. Also, at the monopolist’s Qm
output, product price is considerably higher than marginal cost, which means that
society values additional units of this monopolized product more highly than it val-
ues the alternative products the resources could otherwise produce. So the monop-
olist’s profit-maximizing output results in an underallocation of resources. The
monopolist finds it profitable to restrict output and therefore employ fewer
resources than is justified from society’s standpoint. So the monopolist does not
achieve allocative efficiency.
In monopoly, then, P > MC and P > minimum ATC.

Income Transfer
In general, monopoly transfers income from consumers to stockholders who own
the monopoly. By virtue of their market power, monopolists charge a higher price
than would a purely competitive firm with the same costs. So, monopolists in effect
levy a private tax on consumers and obtain substantial economic profits. These
monopolistic profits are not equally distributed, because higher income groups
largely own corporate stock. The owners of monopolistic enterprises thus tend to be
enriched at the expense of the rest of consumers who overpay for the product.
Because, on average, these owners have more income than the buyers, monopoly
increases income inequality.

Cost Complications
Our evaluation of pure monopoly has led us to conclude that, given identical costs,
a purely monopolistic industry will charge a higher price, produce a smaller output,
and allocate economic resources less efficiently than a purely competitive industry.
These inferior results originate with entry barriers characterizing monopoly.
Now we must recognize that costs may not be the same for purely competitive
and monopolistic producers. The unit cost incurred by a monopolist may be either
larger or smaller than that incurred by a purely competitive firm. There are four rea-
sons why costs may differ: (1) economies of scale, (2) a factor called X-inefficiency,
(3) the need for monopoly-preserving expenditures, and (4) the very long-run per-
spective, which allows for technological advance.

ECONOMIES OF SCALE ONCE AGAIN

Where there are extensive economies of scale, market demand may not be sufficient
to support a large number of competing firms, each producing at minimum efficient
scale. In such cases, an industry of one or two firms would have a lower average
total cost than would the same industry made up of numerous competitive firms.
At the extreme, only a single firm—a natural monopoly—might be able to achieve
the lowest long-run average total cost.
Some firms relating to new information technologies, for example, computer soft-
ware, Internet service, and wireless communications, have displayed extensive
economies of scale. As these firms have grown, their long-run average total costs
simul- have declined. Greater use of specialized inputs, the spreading of product develop-
taneous ment costs, and learning by doing all have produced economies of scale. Also, simul-
consumption taneous consumption and network effects have reduced costs.
A product’s ability to
satisfy a large num-
A product’s ability to satisfy a large number of consumers at the same time is
ber of consumers at called simultaneous consumption (or nonrivalrous consumption). Dell Computers
the same time. needs to produce a personal computer for each customer, but Microsoft needs to
260 Part Two • Microeconomics of Product Markets

produce its Windows program only once. Then, at very low marginal cost, Microsoft
delivers its program by disk to millions of consumers. The same is true for Internet
service providers, music producers, and wireless communication firms. Because
marginal costs are so low, the average total cost of output declines as more cus-
tomers are added.
network Network effects are increases in the value of a product to each user, including exist-
effects ing users, as the total number of users rises. Computer software, cell phones, pagers,
Increases in the palm computers, and other products related to the Internet are good examples. When
value of a product
to each user, includ-
others have Internet service and devices to access it, you can conveniently send e-mail
ing existing ones, messages to them. When they have similar software, documents, spreadsheets, and
as the total number photos can be attached to the e-mail message. The benefits of the product to each per-
of users rises. son are magnified the larger the number of people connected to the system.
Such network effects may drive a market toward monopoly because consumers
tend to choose standard products that everyone else is using. The focused demand
for these products permits their producers to grow rapidly and thus achieve
economies of scale. Smaller firms, which have the higher-cost right products or the
wrong products get acquired or go out of business.
Economists generally agree that some new information firms have not yet
exhausted their economies of scale, but, most economists question whether such
firms are truly natural monopolies. Most firms eventually achieve their minimum
efficient scale at less that the full size of the market, and, even if natural monopoly
develops, it’s unlikely that the monopolist will pass cost reductions along to con-
sumers as price reductions. So, with perhaps a handful of exceptions, economies of
scale do not change the general conclusion that monopolies yield less efficiency than
more competitive industries.

X-INEFFICIENCY
In constructing all the average-total-cost curves used in this book, we have assumed
that the firm uses the most efficient technology. In other words, it uses the technol-
ogy that permits it to achieve the lowest average total cost of whatever level of out-
x-inefficiency put it chooses to produce. X-inefficiency occurs when a firm’s actual cost of
Failure to produce producing any output is greater than the lowest possible cost of producing it. In Fig-
any specific output ure 10-7 X-inefficiency is represented by operation at points X and X⬘ above the
at the lowest
average (and total)
lowest-cost ATC curve. At these points, per-unit costs are ATCx (as opposed to ATC1)
cost possible. for output Q1 and ATCx⬘ (as opposed to ATC2) for output Q2. Any point above the
average-total-cost curve in Figure 10-7 is possible but reflects inefficiency or bad
management by the firm.
Why is X-inefficiency allowed to occur if it reduces profits? The answer is that
managers may have goals such as corporate growth, an easier work life, avoidance
of business risk, or giving jobs to incompetent relatives that conflict with cost min-
imization. Or X-inefficiency may arise because a firm’s workers are poorly moti-
vated or ineffectively supervised. Or a firm may simply become lethargic and inert,
relying on rules of thumb in decision making as opposed to relevant calculations of
costs and revenues.
For our purposes the relevant question is whether monopolistic firms tend more
toward X-inefficiency than competitive producers do. There is evidence that they
<www.maths.tcd.ie/ do. Firms in competitive industries are continually under pressure from rivals, forc-
pub/econrev/ser/html/
morton.html>
ing them to be internally efficient to survive. But monopolists are sheltered from
Monopoly and such competitive forces by entry barriers, and that lack of pressure may lead to
x-efficiency X-inefficiency.
 chapter ten • pure monopoly 261

FIGURE 10-7 X-INEFFICIENCY

The average-total-
cost curve (ATC) is
assumed to reflect
the minimum cost ATCX X

Average total costs

of producing each
particular unit of
output. Any point ATC1
above this lowest-
cost ATC curve, such Average
as X or X⬘, implies X- ATCX ′ X′ total cost
inefficiency: opera-
tion at greater than ATC2
lowest cost for a par-
ticular level of output.

0 Q1 Q2
Quantity

There is no indisputable evidence of X-inefficiency, but what evidence we have

suggests that it increases as the competition decreases. A reasonable estimate is that X-
inefficiency may be 10 percent or more of costs for monopolists but only 5 percent for
an average oligopolistic industry in which the four largest firms produce 60 percent of
total output.1 In the words of one authority: “The evidence is fragmentary, but it points
in the same direction. X-inefficiency exists, and it is more apt to be reduced when com-
petitive pressures are strong than when firms enjoy insulated market positions.”2

RENT-SEEKING EXPENDITURES
rent-seeking Rent-seeking behaviour is an attempt to transfer income or wealth to a particular
behaviour firm or resource supplier at someone else’s, or even society’s, expense. We have seen
The actions by that a monopolist can obtain an economic profit even in the long run. Therefore, it
persons, firms, or
unions to gain spe-
is no surprise that a firm may go to great expense to acquire or maintain a monop-
cial benefits from oly granted by government through legislation or an exclusive licence. Such rent-
government at tax- seeking expenditures add nothing to the firm’s output, but they clearly increase its
payers’ or someone costs. They imply that monopoly involves higher costs and less efficiency than sug-
else’s expense. gested in Figure 10-6(b).

TECHNOLOGICAL ADVANCE
In the very long run, firms can reduce their costs through the discovery and imple-
mentation of new technology. If monopolists are more likely than competitive pro-
ducers to develop more efficient production techniques over time, then the
inefficiency of monopoly might be overstated. Since research and development
(R&D) is the topic of Chapter 12, we will provide only a brief assessment here.

1 William G. Shepherd, The Economics of Industrial Organization, 4th ed. (Englewood Cliffs, NJ:

Prentice-Hall, 1997), p. 107.

2
F. M. Scherer and David Ross, Industrial Market Structure and Economic Performance, 3rd ed.
(Chicago: Rand McNally College Publishing, 1990), p. 672.
262 Part Two • Microeconomics of Product Markets

The general view of economists is that a pure monopolist will not be technolog-
ically progressive. Although its economic profit provides ample means to finance
R&D, it has little incentive to implement new techniques (or products). The absence
of competitors means that no external pressure exists for technological advance in
a monopolized market. Because of its sheltered market position, the pure monopo-
list can afford to be inefficient and lethargic; there simply is no penalty for being so.
One caveat: Research and technological advance may be one of the monopolist’s
barriers to entry. Thus, the monopolist may continue to seek technological advance
to avoid falling prey to new rivals. In this case technological advance is essential to
the maintenance of monopoly, but it is potential competition, not the monopoly
market structure, that is driving the technological advance. By assumption, no such
competition exists in the pure monopoly model; entry is completely blocked.

Assessment and Policy Options

Monopoly is a legitimate concern to an economy. Monopolists can charge higher-
than-competitive prices that result in an underallocation of resources to the monop-
olized product. Monopolists can stifle innovation, engage in rent-seeking behaviour,
and foster X-inefficiency. Even when their costs are low because of economies of scale,
monopolists make no guarantee that the price they charge will reflect those low costs.
The cost savings may simply accrue to the monopoly as greater economic profit.
Fortunately, however, monopoly is not widespread in the economy. Barriers to
entry are seldom completely successful. Although research and technological
advance may strengthen the market position of a monopoly, technology may also
undermine monopoly power. Over time, the creation of new technologies may work
to destroy monopoly positions. For example, the development of courier delivery, fax
machines, and e-mail has eroded the monopoly power of Canada Post Corporation.
Cable television monopolies are now challenged by satellite TV and by new tech-
nologies that permit the transmission of audio and visual signals over the Internet.
Similarly, patents eventually expire and even before they do, the development of
new and distinct substitutable products often circumvents existing patent advan-
tages. New sources of monopolized resources sometimes are found, and competi-
tion from foreign firms may emerge. Finally, if a monopoly is sufficiently fearful of
future competition from new products, it may keep its prices relatively low to dis-
courage rivals from developing such products. If so, consumers may pay nearly
competitive prices even though present competition is lacking.
So what should government do about monopoly when it arises in the real world?
Economists agree that government needs to look carefully at monopoly on a case-
by-case basis. Three general policy options are available:
1. If the monopoly is achieved and sustained through anticompetitive actions, creates
substantial economic inefficiency, and appears to be long lasting, the government
can file charges against the monopoly under Canada’a anti-combines laws. If
found guilty of monopoly abuse, the firm can either be expressly prohibited from
engaging in certain business activities or broken into two or more competing firms.
2. If the monopoly is a natural monopoly, society can allow it to continue expand-
ing. If no competition emerges from new products, government may then decide
to regulate its prices and operations.
3. If the monopoly appears to be unsustainable over a long period, say, because of
emerging new technology, society can simply choose to ignore it.
 chapter ten • pure monopoly 263

● The monopolist maximizes profit (or minimizes
loss) at the output where MR = MC and charges
the price that corresponds to that output on its
demand curve.
● The monopolist has no supply curve, since any
of several prices can be associated with a spe-
cific quantity of output supplied.
● Assuming identical costs, a monopolist will be
less efficient than a purely competitive industry
because the monopolist produces less output
and charges a higher price.
● The inefficiencies of monopoly may be offset or
lessened by economies of scale and, less likely,
by technological progress, but may be intensi-
fied by the presence of X-inefficiency and rent-
seeking expenditures.

Price Discrimination
We have assumed in this chapter that the monopolist charges a single price to all
buyers. But under certain conditions the monopolist can increase its profit by charg-
ing different prices to different buyers. In so doing, the monopolist is engaging in
price dis- price discrimination, the practice of selling a specific product at more than one
crimination price when the price differences are not justified by cost differences.
The selling of a
product to different
buyers at different
prices when the
Conditions
price differences are The opportunity to engage in price discrimination is not readily available to all sell-
not justified by dif- ers. Price discrimination is possible when the following conditions are realized:
ferences in cost.
● Monopoly power The seller must be a monopolist or, at least, possess some
degree of monopoly power, that is, some ability to control output and price.
● Market segregation The seller must be able to segregate buyers into distinct
classes, each of which has a different willingness or ability to pay for the prod-
uct. This separation of buyers is usually based on different elasticities of
demand, as the examples that follow will make clear.
● No resale The original purchaser cannot resell the product or service. If buy-
ers in the low-price segment of the market could easily resell in the high-price
segment, the monopolist’s price-discrimination strategy would create compe-
tition in the high-price segment. This competition would reduce the price in
the high-price segment and undermine the monopolist’s price-discrimination
policy. This condition suggests that service industries such as the transporta-
tion industry or legal and medical services, where resale is impossible, are
candidates for price discrimination.

Examples of Price Discrimination

Price discrimination is widely practised in the Canadian economy. For example, air-
lines charge high fares to travelling executives, whose demand for travel is inelastic,
and offer lower fares such as “family rates” and “14-day advance purchase fares”
to attract vacationers and others whose demands are more elastic.
 264 Part Two • Microeconomics of Product Markets

Electric utilities frequently segment their markets by end uses, such as lighting
and heating. The absence of reasonable lighting substitutes means that the demand
for electricity for illumination is inelastic and that the price per kilowatt-hour for
<classes.aces.uiuc.edu/ such use is high. But the availability of natural gas and petroleum for heating makes
ACE325/prdisc.html> the demand for electricity for this purpose less inelastic and the price lower.
Price discrimination Movie theatres and golf courses vary their charges on the basis of time (higher
rates in the evening and on weekends when demand is strong) and age (ability to
pay). Railroads vary the rate charged per tonne-kilometre of freight according to the
market value of the product being shipped. The shipper of 10 tonnes of television sets
or costume jewellery is charged more than the shipper of 10 tonnes of gravel or coal.
The issuance of discount coupons, redeemable at purchase, is a form of price dis-
crimination. It permits firms to give price discounts to their most price-sensitive cus-
tomers who have elastic demand. Less price-sensitive consumers who have less
elastic demand are not as likely to undertake the clipping and redeeming of
coupons. The firm thus makes a larger profit than if it had used a single-price, no-
coupon strategy.
Finally, price discrimination often occurs in international trade. A Russian alu-
minum producer, for example, might sell aluminum for less in Canada than in Rus-
sia. In Canada, this seller faces an elastic demand because several substitute
suppliers are available. But in Russia, where the manufacturer dominates the mar-
ket and trade barriers impede imports, consumers have fewer choices and thus
demand is less elastic.

Consequences of Price Discrimination

As you will see shortly, a monopolist can increase its profit by practising price dis-
crimination. At the same time, perfect price discrimination results in more output than
would be purchased at a single monopoly price. Such price discrimination occurs
when the monopolist charges each customer the price that he or she would be will-
ing to pay rather than forgo the product.

MORE PROFIT
Let’s again consider our monopolist’s downsloping demand curve in Figure 10-4,
this time to see why price discrimination can yield additional profit. In that figure
we saw that the profit-maximizing single price is Pm = $122. However, the segment
of the demand curve above the economic profit area (in grey) reveals that some buy-
ers are willing to pay more than $122 rather than forgo the product.
If the monopolist can identify those buyers, segregate them, and charge the max-
imum price each would be willing to pay, total revenue and economic profit would
increase. Observe from columns 1 and 2 in Table 10-1 that buyers of the first four
units of output would be willing to pay $162, $152, $142, and $132, respectively, for
those units. If the seller could practise perfect price discrimination by charging the
maximum price for each unit, total revenue would increase from $610 (= $122 × 5)
to $710 (= $122 + $132 + $142 + $152 + $162) and profit would increase from $140
(= $610 – $470) to $240 (= $710 – $470).

MORE PRODUCTION
Other things being equal, the monopolist practising perfect price discrimination
will produce a larger output than the monopolist that does not. When the non-
discriminating monopolist lowers its price to sell additional output, the lower price
 chapter ten • pure monopoly 265

not only applies to the additional output but also to all the prior units of output. So
the single-price monopolist’s marginal revenue falls more rapidly than price and,
graphically, its marginal-revenue curve lies below its demand curve. The decline of
marginal revenue is a disincentive to increased production.
When a discriminating monopolist lowers its price, the reduced price applies
only to the additional units sold and not to the prior units. Thus, marginal revenue
equals price for each unit of output and the firm’s marginal revenue curve and
demand curve coincide. The disincentive to increased production is removed.
We can show the outcome through Table 10-1. Because marginal revenue and
price are equal, the discriminating monopolist finds it profitable to produce seven
units, not five units, of output. The additional revenue from the sixth and seventh
units is $214 (= $112 + $102). Thus, total revenue for seven units is $924 (= $710 +
$214). Since total cost for seven units is $640, profit is $284.
Ironically, although perfect price discrimination results in higher monopoly profit
than that achieved by a nondiscriminating monopolist, it also results in greater out-
put and thus less allocative inefficiency. In our example, the output level of seven
units matches the output that would have occurred in pure competition; that is,
allocative efficiency (P = MC) is achieved.

GRAPHICAL PORTRAYAL
Figure 10-8 shows the effects of price discrimination graphically. Figure 10-8(a)
merely reproduces Figure 10-4 in a generalized form to show the position of a
nondiscriminating monopolist as a benchmark. The nondiscriminating monopolist
produces output Q1 (where MR = MC) and charges price P1. Total revenue is area
0bce and economic profit is area abcd.

FIGURE 10-8 SINGLE-PRICE VERSUS PERFECTLY DISCRIMINATING

MONOPOLY PRICING

f f
Economic Economic
profit MC profit MC
Price and costs

Price and costs

ATC ATC
P1 b c c
g

A1 d A2 h
a j

e MR D k D = MR
0 Q1 0 Q1 Q2
Quantity Quantity
(a) Single-price monopolist (b) Perfectly discriminating monopolist
Panel (a): The single-price monopolist produces output Q1 at which MR = MC, charges price P1 for all units, incurs an average
total cost of A1, and realizes an economic profit represented by area abcd. Panel (b): The perfectly discriminating monopolist
has D = MR and, as a result, produces output Q2 (where MR = MC). It then charges the maximum price for each unit of output,
incurs average total cost A2, and realizes an economic profit represented by area hfgj.
266 Part Two • Microeconomics of Product Markets

The monopolist in Figure 10-8(b) engages in perfect price discrimination, charg-

ing each buyer the highest price he or she is willing to pay. Starting at the very first
unit, each additional unit is sold for the price indicated by the corresponding point
on the demand curve. This monopolist’s demand and marginal-revenue curves
coincide, because the monopolist does not cut price on preceding units to sell more
output. Thus, the most profitable output is Q2 (where MR = MC), which is greater
than Q1. Total revenue is area 0fgk and total cost is area 0hjk. The economic profit of
hfgj for the discriminating monopolist is clearly larger than the profit of abcd for the
single-price monopolist.
The impact of price discrimination on consumers is mixed. Those buying each unit
up to Q1 will pay more than the nondiscriminatory price of P1. But those additional
consumers brought into the market by discrimination will pay less than P1. Specifi-
cally, they will pay the various prices shown on segment cg of the D = MR curve.
Overall, then, as compared with uniform pricing, perfect price discrimination
results in greater profit, greater output, and higher prices for many consumers but
lower prices for those purchasing the extra output. (Key Question 6)

Regulated Monopoly
Natural monopolies traditionally have been subject to rate regulation (price regula-
The Role of
Governments tion), although the recent trend has been to deregulate those parts of the industries
where competition seems possible. Provincial or municipal regulatory commissions
still regulate the prices that municipal natural gas distributors, regional telephone
companies, and municipal electricity suppliers can charge. But long-distance tele-
phone, natural gas at the well-head, wireless communications, cable television, and
long-distance electricity transmission have been, to one degree or another, deregu-
lated over the past several decades, and competition among local telephone, elec-
tricity, and natural gas providers is now beginning.
Let’s consider the regulation of a local natural monopoly, for example, a natural gas
distributor. Figure 10-9 shows the demand and the long-run costs curves facing our
firm. Because of extensive economies of scale, the demand curve cuts the natural
monopolist’s long-run average-total-cost curve at a point where that curve is still

FIGURE 10-9 REGULATED MONOPOLY

The socially optimal
price Pr, found where
Price and costs (dollars)

D and MC intersect, Monopoly

will result in an effi- price
cient allocation of Pm Fair-return
resources but may price
Socially
entail losses to the optimal
monopoly. The fair- f price
Pf ATC
return price Pf will a
allow the monopolist Pr MC
to break even but will r
not fully correct the
underallocation of MR b D
resources. 0 Qm Qf Qr
Quantity
 chapter ten • pure monopoly 267

falling. It would be inefficient to have several firms in this industry because each
would produce a much smaller output, operating well to the left on the long-run
average-total-cost curve. In short, each firms’ lowest average total cost would be sub-
stantially higher than that of a single firm. So, this circumstance requires a single seller.
We know by application of the MR = MC rule that Qm and Pm are the profit-
maximizing output and price that an unregulated monopolist would choose.
Because price exceeds average total cost at output Qm, the monopolist enjoys a sub-
stantial economic profit. Furthermore, price exceeds marginal cost, indicating an
underallocation of resources to this product or service. Can government regulation
bring about better results from society’s point of view?

Socially Optimal Price: P = MC

If the objective of a regulatory commission is to achieve allocative efficiency, it
should attempt to establish a legal (ceiling) price for the monopolist that is equal to
marginal cost. Remembering that each point on the market demand curve desig-
nates a price–quantity combination, and noting that the marginal-cost curve cuts the
demand curve only at point r, we see that Pr is the only price on the demand curve
equal to marginal cost. The maximum or ceiling price effectively causes the monop-
olist’s demand curve to become horizontal (indicating perfectly elastic demand)
from zero out to point r, where the regulated price ceases to be effective. Also, out
to point r we have MR = Pr.
Confronted with the legal price Pr, the monopolist will maximize profit or mini-
mize loss by producing Qr units of output, because at this output MR (= Pr) = MC.
By making it illegal to charge more than Pr per unit, the regulatory agency has
removed the monopolist’s incentive to restrict output to Qm to obtain a higher price
and greater profit.
In short, the regulatory commission can simulate the allocative forces of pure com-
petition by imposing the legal price Pr and letting the monopolist choose its profit-
maximizing or loss-minimizing output. Production takes place where Pr = MC, and
this equality indicates an efficient allocation of resources to this product or service.
socially The price that achieves allocative efficiency is called the socially optimal price.
optimal
price The price
of a product that Fair-Return Price: P = ATC
results in the most It is possible for the socially optimal price, Pr, that equals marginal cost to be so low
efficient allocation
of an economy’s that average total costs are not covered, as is the case in Figure 10-9. The result is a
resources. loss for the firm. The reason lies in the basic character of our firm. Because it is
required to meet the heaviest peak demands (both daily and seasonally) for natural
gas, it has substantial excess production capacity when demand is relatively “nor-
mal.” Its high level of investment in production facilities and economies of scale
mean that its average total cost is likely to be greater than its marginal cost over a
very wide range of outputs. In particular, as in Figure 10-9, average total cost is likely
to be greater than the price Pr at the intersection of the demand curve and marginal-
fair-return cost curve. Therefore, forcing the socially optimal price Pr on the regulated monop-
price The price olist would result in short-run losses and long-run bankruptcy for the utility.
of a product that What to do? One option is to provide a public subsidy to cover the loss that
enables its producer marginal-cost pricing would entail. Another possibility is to condone price discrim-
to obtain a normal ination and hope that the additional revenue gained will permit the firm to cover costs.
profit and that is
equal to the In practice, regulatory commissions have pursued a third option: They modify
average cost of the objective of allocative efficiency and P = MC pricing. Most regulatory agencies
producing it. in Canada establish a fair-return price.
268 Part Two • Microeconomics of Product Markets

Remembering that total cost includes a normal or “fair” profit, we see in Figure
10-9 that a fair-return price should be on the average-total-cost curve. Because the
demand curve cuts average total cost only at point f, clearly Pf is the only price on
the demand curve that permits a fair return. The corresponding output at regulated
price Pf will be Qf. Total revenue of 0afb will equal the utility’s total cost of the same
amount, and the firm will realize a normal profit.

Dilemma of Regulation
Comparing results of the socially optimal price (P = MC) and the fair-return price
(P = ATC) suggests a policy dilemma, sometimes termed the dilemma of regulation.
When its price is set to achieve the most efficient allocation of resources (P = MC),
the regulated monopoly is likely to suffer losses. Survival of the firm would pre-
sumably depend on permanent public subsidies from tax revenues. Conversely,
although a fair-return price (P = ATC) allows the monopolist to cover costs, it only
partially resolves the underallocation of resources that the unregulated monopoly
price would foster. That is, the fair-return price would increase output only from Qm
to Qf in Figure 10-9, while the socially optimal output is Qr. Despite this dilemma,
regulation can improve on the results of monopoly from the social point of view.
Price regulation (even at the fair-return price) can simultaneously reduce price,
increase output, and reduce the economic profits of monopolies. (Key Question 11)

● Price discrimination occurs when a firm sells a
product at different prices that are not based on
cost differences.
● The conditions necessary for price discrimination
are (1) monopoly power, (2) the ability to segre-
gate buyers based on demand elasticities, and
(3) the inability of buyers to resell the product.
● Compared with single pricing by a monopolist,
perfect price discrimination results in greater
profit and greater output. Many consumers pay
higher prices, but other buyers pay prices below
the single price.
● Monopoly price can be reduced and output
increased through government regulation.
● The socially optimal price (P = MC) achieves
allocative efficiency but may result in losses;
the fair-return price (P = ATC) yields a normal
profit but falls short of allocative efficiency.

DE BEERS’ DIAMONDS: ARE

De Beers, a Swiss-based cartel
controlled by a South African
corporation, produces about 50
percent of the world’s rough-cut
MONOPOLIES FOREVER?
De Beers was one of the world’s strongest and most
enduring monopolies. But in mid-2000 it announced
that it could no longer control the supply of diamonds
and thus would abandon its 66-year policy of
monopolizing the diamond trade.
diamonds and purchases for re- result, De Beers markets 63 per-
sale a sizable number of the cent of the world’s diamonds
rough-cut diamonds produced to a select group of diamond
by other mines worldwide. As a cutters and dealers, but that

percentage has declined from 80
percent in the mid-1980s and
continues to shrink. Therein lies
De Beers’ problem.
Classic Monopoly Behaviour
De Beers’ past monopoly behav-
iour and results are a classic ex-
ample of the unregulated mo-
nopoly model illustrated in Figure
10-4. No matter how many dia-
monds it mined or purchased, De
Beers sold only that quantity of
diamonds that would yield an ap-
propriate (monopoly) price. That
price was well above production
costs, and De Beers and its part-
ners earned monopoly profits.
When demand fell, De Beers
reduced it sales to maintain price.
The excess of production over
sales was then reflected in grow-
ing diamond stockpiles held by
De Beers. It also attempted to
bolster demand through adver-
tising (“Diamonds are forever”).
When demand was strong, it in-
creased sales by reducing its dia-
mond inventories.
De Beers used several meth-
ods to control the production of
many mines it did not own. First,
it convinced a number of inde-
pendent producers that single-
channel or monopoly marketing
through De Beers would maxi-
mize their profit. Second, mines
that circumvented De Beers
often found their market sud-
denly flooded with similar dia-
monds from De Beers’ vast
stockpiles. The resulting price
chapter ten • pure monopoly
decline and loss of profit often
would encourage the “rogue”
mine into the De Beers fold. Fi-
nally, De Beers simply pur-
chased and stockpiled diamonds
produced by independent mines
so their added supplies would
not undercut the market.
An End of an Era?
Several factors have come to-
gether to unravel the monopoly.
New diamond discoveries re-
sulted in a growing leakage of
diamonds into world markets
outside De Beers’ control. For
example, significant prospecting
and trading in Angola occurred.
Recent diamond discoveries in
Canada’s Northwest Territories
pose another threat. Although
De Beers is a participant in that
region, a large uncontrolled sup-
ply of diamonds is expected to
emerge. Similarly, although Rus-
sia is part of the De Beers’ mo-
nopoly, this cash-strapped coun-
try is allowed to sell part of its
diamond stock directly into the
world markets.
As if that were not enough,
Australian diamond producer
269
Argyle opted to withdraw from
the De Beers monopoly. Its an-
nual production of mostly low-
grade industrial diamonds ac-
counts for about 6 percent of the
global $8 billion diamond mar-
ket. The international media has
begun to focus heavily on the
role that diamonds play in fi-
nancing the bloody civil wars in
Africa. Fearing a consumer boy-
cott of diamonds, De Beers has
pledged not to buy these conflict
diamonds or do business with
any firms that does. These dia-
monds, however, continue to
find their way into the market-
place, eluding De Beers’ control.
In mid-2000 De Beer’s aban-
doned its attempt to control the
supply of diamonds. It an-
nounced that it planned to trans-
form itself from a diamond cartel
to a modern firm selling premium
diamonds and other luxury goods
under the De Beers label. It, there-
fore, would gradually reduce its
$4 billion stockpile of diamonds
and turn its efforts to increasing
the overall demand for diamonds
through advertising. De Beers
proclaimed that it was changing
its strategy to being “the dia-
mond supplier of choice.”
With its high market share
and ability to control its own
production levels, De Beers will
still wield considerable influence
over the price of rough-cut dia-
monds, but it turns out that the
De Beers monopoly was not
forever.
270 Part Two • Microeconomics of Product Markets
chapter summary
1. A pure monopolist is the sole producer of
a commodity for which there are no close
substitutes.
2. The existence of pure monopoly and other
imperfectly competitive market structures is
explained by barriers to entry, in the form of
(a) economies of scale, (b) patent ownership
and research, (c) ownership or control of
essential resources, and (d) pricing and other
strategic behaviour.
3. The pure monopolist’s market situation dif-
fers from that of a competitive firm in that the
monopolist’s demand curve is downsloping,
causing the marginal-revenue curve to lie
below the demand curve. Like the competitive
seller, the pure monopolist will maximize
profit by equating marginal revenue and mar-
ginal cost. Barriers to entry may permit a
monopolist to acquire economic profit even in
the long run. However, (a) the monopolist
does not charge the highest price it can get;
(b) the price that yields maximum total profit
to the monopolist rarely coincides with the
price that yields maximum unit profit; (c) high
costs and a weak demand may prevent the
monopolist from realizing any profit at all;
and (d) the monopolist avoids the inelastic
region of its demand curve.
4. With the same costs, the pure monopolist will
find it profitable to restrict output and charge
a higher price than would sellers in a purely
competitive industry. This restriction of out-
put causes resources to be misallocated, as is
evidenced by the fact that price exceeds mar-
ginal cost in monopolized markets.
terms and concepts
pure monopoly, p. 246 network effects, p. 260
barriers to entry, p. 247 X-inefficiency, p. 260
simultaneous consumption, rent-seeking behaviour,
p. 259 p. 261
study questions
1. “No firm is completely sheltered from rivals;
all firms compete for consumer dollars. If that
is so, then pure monopoly does not exist.” Do
5. In general, monopoly increases income in-
equality by transferring income from con-
sumers to the owners of the monopoly.
6. The costs monopolists and competitive pro-
ducers face may not be the same. On the one
hand, economies of scale may make lower
unit costs available to monopolists but not
to competitors, and pure monopoly may be
more likely than pure competition to reduce
costs via technological advance because of
the monopolist’s ability to realize economic
profit, which can be used to finance research.
On the other hand, X-inefficiency—the failure
to produce with the least costly combination
of inputs—is more common among monopo-
lists than among competitive firms. Also,
monopolists may make costly expenditures
to maintain monopoly privileges that are con-
ferred by government. Finally, the blocked
entry of rival firms weakens the monopolist’s
incentive to be technologically progressive.
7. A monopolist can increase its profit by practis-
ing price discrimination, provided (a) it can seg-
regate buyers on the basis of elasticities of
demand and (b) its product or service cannot
be readily transferred between the segregated
markets. Other things being equal, the perfectly
discriminating monopolist will produce a larger
output than the nondiscriminating monopolist.
8. Price regulation can be invoked to eliminate
wholly or partially the tendency of monopo-
lists to underallocate resources and to earn
economic profits. The socially optimal price is
determined where the demand and marginal-
cost curves intersect; the fair-return price is
determined where the demand and average-
total-cost curves intersect.
price discrimination, p. 263
socially optimal price, p. 267
fair-return price, p. 267
you agree? Explain. How might you use
Chapter 6’s concept of cross elasticity of
demand to judge whether monopoly exists?
 chapter ten • pure monopoly 271

2. Discuss the major barriers to entry into an Quantity Total Marginal

industry. Explain how each barrier can foster Price demanded revenue revenue
either monopoly or oligopoly. Which barri-
ers, if any, do you feel give rise to monopoly $115 0 $______
$______
that is socially justifiable? 100 1 ______
______
3. How does the demand curve faced by a 83 2 ______
______
purely monopolistic seller differ from that 71 3 ______
confronting a purely competitive firm? Why ______
63 4 ______
does it differ? Of what significance is the dif- ______
55 5 ______
ference? Why is the pure monopolist’s de- ______
mand curve not perfectly inelastic? 48 6 ______
______
42 7 ______
4. KEY QUESTION Use the demand ______
schedule that follows to calculate total rev- 37 8 ______
______
enue and marginal revenue at each quan- 33 9 ______
tity. Plot the demand, total-revenue, and ______
29 10 ______
marginal-revenue curves, and explain the
relationships between them. Explain why the 6. KEY QUESTION If the firm described
marginal revenue of the fourth unit of output in question 5 could engage in perfect price
is $3.50, even though its price is $5.00. Use discrimination, what would be the level of
Chapter 6’s total-revenue test for price elas- output? of profits? Draw a diagram showing
ticity to designate the elastic and inelastic the relevant demand, marginal-revenue,
segments of your graphed demand curve. average-total-cost, and marginal-cost curves,
What generalization can you make about the and the equilibrium price and output for a
relationship between marginal revenue and nondiscriminating monopolist. Use the same
elasticity of demand? Suppose the marginal diagram to show the equilibrium position of
cost of successive units of output were zero. a monopolist that is able to practise perfect
What output would the profit-seeking firm price discrimination. Compare equilibrium
produce? Finally, use your analysis to explain outputs, total revenues, economic profits,
why a monopolist would never produce in and consumer prices in the two cases. Com-
the inelastic region of demand. ment on the economic desirability of price
discrimination.
Quantity Quantity
Price (P) demanded (Q) Price (P) demanded (Q) 7. Assume that a pure monopolist and a purely
competitive firm have the same unit costs.
$7.00 0 $4.50 5 Contrast the two with respect to (a) price,
6.50 1 4.00 6 (b) output, (c) profits, (d) allocation of
resources, and (e) impact on the distribution
6.00 2 3.50 7
of income. Since both monopolists and com-
5.50 3 3.00 8 petitive firms follow the MC = MR rule in
5.00 4 2.50 9 maximizing profits, how do you account for
the different results? Why might the costs of
5. KEY QUESTION Suppose a pure a purely competitive firm and a monopolist
monopolist is faced with the demand sched- be different? What are the implications of
ule shown in the next column and the same such a cost difference?
cost data as the competitive producer dis- 8. Critically evaluate and explain:
cussed in question 4 at the end of Chapter 9.
Calculate the missing total-revenue and a. “Because they can control product price,
marginal-revenue amounts, and determine monopolists are always assured of prof-
the profit-maximizing price and profit- itable production by simply charging the
earning output for this monopolist. What highest price consumers will pay.”
is the monopolist’s profit? Verify your b. “The pure monopolist seeks the out-
answer graphically and by comparing total put that will yield the greatest per-unit
revenue and total cost. profit.”
272 Part Two • Microeconomics of Product Markets
c. “An excess of price over marginal cost is
the market’s way of signalling the need
for more production of a good.”
d. “The more profitable a firm, the greater
its monopoly power.”
e. “The monopolist has a pricing policy; the
competitive producer does not.”
f. “With respect to resource allocation, the
interests of the seller and of society coin-
cide in a purely competitive market but
conflict in a monopolized market.”
g. “In a sense the monopolist makes a profit
for not producing; the monopolist pro-
duces profit more than it does goods.”
9. Assume a monopolistic publisher has agreed
to pay an author 15 percent of the total rev-
enue from the sales of a text. Will the author
and the publisher want to charge the same
price for the text? Explain.
10. Explain verbally and graphically how price
(rate) regulation may improve the per-
internet application question
1. Use the information at <usvms.gpo.gov/
conclusions_index.html> to answer the fol-
lowing questions: On what basis did the
American Federal District Court conclude
that Microsoft was a monopoly? (See the
section on monopoly power.) What specific
percentage market share did it attribute to
Microsoft? Go to <usvms.gpo.gov> to dis-
formance of monopolies. In your answer
distinguish between (a) socially optimal
(marginal-cost) pricing and (b) fair-return
(average-total-cost) pricing. What is the
“dilemma of regulation”?
11. KEY QUESTION It has been pro-
posed that natural monopolists should be
allowed to determine their profit-maximizing
outputs and prices and then government
should tax their profits away and distribute
them to consumers in proportion to their
purchases from the monopoly. Is this pro-
posal as socially desirable as requiring
monopolists to equate price with marginal
cost or average total cost?
12. (The Last Word) How was De Beers able to
control the world price of diamonds over the
past several decades even though it pro-
duced only 50 percent of the diamonds?
What factors ended its monopoly? What is
De Beers’ new strategy for earning economic
profit, rather than just normal profit?
cover the Court’s main remedy for reducing
Microsoft’s monopoly power. Finally, Micro-
soft has appealed the District Court decision
to a higher court. Use the Internet to deter-
mine the present status of the appeal. Is the
appeal still pending? Has the District Court
decision been upheld? overturned?
 ELEVEN

Monopolistic
Competition
and
Oligopoly
IN THIS CHAPTER

M
Y OU WILL LEARN: ost market structures in the Cana-

The conditions necessary for dian economy fall between the two
monopolistic competition to arise.
• extremes of pure competition and
How the profit-maximizing price
and output are determined in pure monopoly. In this chapter we develop
monopolistic competition.
• models of monopolistic competition and oli-
The necessary conditions for
oligopoly to arise. gopoly that more closely approximate real-
•
About monopolistic competition world market structures.
and non-price competition.
•
How game theory can help explain
the behaviour of oligopolists.
•
About three oligopoly models.
•
About the debate over the
impact of advertising on
consumers and firms.
•
Why oligopoly achieves neither
productive nor allocative efficiency.
 274 Part Two • Microeconomics of Product Markets

Monopolistic competition exhibits a considerable amount of competition mixed

with a small dose of monopoly power. For example, when you go out to eat, you
have an amazing variety of choices. You can get a meal at a fast-food place such as
McDonald’s, Subway, or Taco Bell. You can go to a restaurant with a fuller menu and
table service. For a special meal you can choose an Italian, a French, or a Japanese
fine-food restaurant where your bill may be $30 or more per person. Each estab-
lishment serves food and beverages, but all have different menus and prices. Com-
petition among them is based not only on price but also on product quality, location,
service, and advertising.
Oligopoly, in contrast, displays a blend of greater monopoly power, less compe-
tition via entry, and more strategic behaviour. There are only a few firms in an oli-
gopolistic industry, and entry is difficult. For example, when you fly on a large
commercial aircraft you are probably flying in a plane built by one of two world pro-
ducers: Airbus or Boeing. In many manufacturing, mining, and wholesaling indus-
tries only a few firms dominate, not the thousands of producers present in pure
competition, the many firms in monopolistic competition, or the single firm in
monopoly.

Monopolistic Competition
monopolis- Let’s begin by examining monopolistic competition, which is characterized by (1) a
tic competi- relatively large number of sellers, (2) differentiated products (often promoted by
tion A market heavy advertising), and (3) easy entry to, and exit from, the industry. The first and
structure in which
many firms sell a
third characteristics provide the competitive aspect of monopolistic competition; the
differentiated prod- second characteristic provides the monopolistic aspect. In general, however, monop-
uct and entry into olistically competitive industries are more competitive than they are monopolistic.
and exit from the
market is relatively
easy. Relatively Large Number of Sellers
product dif- Monopolistic competition is characterized by a fairly large number of firms, say, 25,
ferentiation 35, 60, or 70, not by the hundreds or thousands of firms in pure competition. Con-
A form of nonprice sequently, monopolistic competition involves
competition in
which a firm tries ● Small market shares Each firm has a comparatively small percentage of the
to distinguish its total market and consequently has limited control over market price.
product or service
from all competing ● No collusion The presence of a relatively large number of firms makes col-
ones based on lusion by a group of firms to restrict output and set prices unlikely.
attributes such as
design and quality. ● Independent action With numerous firms in an industry, there is little inter-
dependence among them; each firm can determine its own pricing policy with-
out considering the possible reactions of rival firms. A single firm may realize
a modest increase in sales by cutting its price, but the effect of that action
on competitors’ sales will be nearly imperceptible and will probably not trig-
ger a response.

Differentiated Products
<www.theshortrun.com/ In contrast to pure competition in which there is a standardized product, monopo-
classroom/glossary/
micro/monocomp.html>
listic competition is distinguished by product differentiation. Monopolistically
Monopolistic competitive firms turn out variations of a particular product. They produce prod-
competition ucts with slightly different physical characteristics; offer varying degrees of
 chapter eleven • monopolistic competition and oligopoly 275

customer service; provide varying amounts of location convenience; or proclaim

special qualities, real or imagined, for their products.
Let’s examine these aspects of product differentiation in more detail.

PRODUCT ATTRIBUTES
Product differentiation may take the form of physical or qualitative differences in
the products themselves. Real differences in functional features, materials, design,
and quality of work are vital aspects of product differentiation. Personal computers,
for example, differ in terms of storage capacity, speed, graphic displays, and
included software. There are dozens of competing principles of economics text-
books that differ in content, organization, presentation and readability, pedagogical
aids, and graphics and design. Most cities have a variety of retail stores selling
men’s and women’s clothing that differ greatly in styling, materials, and quality of
work. Similarly, one furniture manufacturer may feature its solid oak furniture,
while a competitor stresses its solid maple furniture.

SERVICE
Service and the conditions surrounding the sale of a product are forms of product
differentiation, too. One grocery store may stress the helpfulness of its clerks who
bag your groceries and carry them to your car. A warehouse competitor may leave
bagging and carrying to its customers but feature lower prices. Customers may pre-
fer one-day over three-day dry cleaning of equal quality. The prestige appeal of a
store, the courteousness and helpfulness of clerks, the firm’s reputation for servic-
ing or exchanging its products, and the credit it makes available are all service
aspects of product differentiation.

LOCATION
Products may also be differentiated through the location and accessibility of the
stores that sell them. Small convenience stores manage to compete with large super-
markets, even though these minimarts have a more limited range of products and
charge higher prices. They compete mainly on the basis of location—being close to
customers and situated on busy streets. A motel’s proximity to an interstate high-
way gives it a locational advantage that may enable it to charge a higher room rate
than nearby motels in less convenient locations.

BRAND NAMES AND PACKAGING

Product differentiation may also be created through the use of brand names and
trademarks, packaging, and celebrity connections. Most aspirin tablets are very
much alike, but many headache sufferers believe that one brand—for example,
Bayer, Anacin, or Bufferin—is superior and worth a higher price than a generic sub-
stitute. A celebrity’s name associated with jeans, perfume, or athletic equipment
may enhance the appeal of those products for some buyers. Many customers prefer
one style of ballpoint pen to another. Packaging touting natural spring bottled water
may attract additional customers versus other bottled waters.

SOME CONTROL OVER PRICE

Despite the relatively large number of firms, monopolistic competitors do have
some control over their product prices because of product differentiation. If con-
sumers prefer the products of specific sellers, then within limits they will pay more
to satisfy their preferences. Sellers and buyers are not linked randomly, as in a
276 Part Two • Microeconomics of Product Markets

purely competitive market. But the monopolistic competitor’s control over price is
quite limited, since there are numerous potential substitutes for its product.

Easy Entry and Exit

Entry into monopolistically competitive industries is relatively easy compared to
oligopoly or pure monopoly. Because monopolistic competitors are typically small
firms, both absolutely and relatively, economies of scale are few and capital require-
ments are low. However, compared with pure competition, financial barriers may
result from the need to develop and advertise a different product from one’s rivals.
Some firms may hold patents on their products or copyrights on their brand names,
making it difficult and costly for other firms to imitate them.
Exit from monopolistically competitive industries is easier still. Nothing prevents
an unprofitable monopolistic competitor from holding a going-out-of-business sale
and shutting down.

Advertising
The expense and effort involved in product differentiation would be wasted if con-
sumers were not made aware of product differences. Thus, monopolistic competi-
tors advertise their products, often heavily. The goal of product differentiation and
nonprice advertising—so-called nonprice competition—is to make price less of a factor in
competition consumer purchases and product differences a greater factor. If successful, the
A selling strategy in firm’s demand curve will shift to the right and will become less elastic.
which one firm tries
to distinguish its
product or service Monopolistically Competitive Industries
from all competing
ones based on Figure 11-1 lists several manufacturing industries that approximate monopolistic
attributes other competition in Canada. In addition, many retail establishments in metropolitan
than price. areas are monopolistically competitive, including grocery stores, gasoline stations,
barbershops, dry cleaners, clothing stores, and restaurants.

Price and Output in

Monopolistic Competition
We now analyze the price and output decisions of a monopolistically competitive
firm. Initially, we assume that each firm in the industry is producing a specific
differentiated product and engaging in a particular amount of advertising. Later
we’ll see how changes in the product and in the amount of advertising modify our
conclusions.

The Firm’s Demand Curve

Our explanation of the price and output decisions of a monopolistically competitive
firm is based on Figure 11-2 (Key Graph). The basic feature of that diagram is the
elasticity of demand, as shown by the individual firm’s demand curve. The demand
curve faced by a monopolistically competitive seller is highly, but not perfectly, elas-
tic. It is precisely this feature that distinguishes monopolistic competition from pure
monopoly and pure competition. The monopolistic competitor’s demand is more
elastic than the demand faced by a pure monopolist because the monopolistically
competitive seller has many competitors producing closely substitutable goods. The
 chapter eleven • monopolistic competition and oligopoly 277

FIGURE 11-1 PERCENTAGE OF OUTPUT PRODUCED BY

THE FOUR LARGEST FIRMS IN SELECTED LOW-
CONCENTRATION SECTORS*

Food
Wood industries
Leather products
Finance
Knitting mills
Machinery
Metal fabricating
Retail trade
Furniture industry
Wholesale trade
Clothing industry

0 5 10 15 20 25 30
Percentage of industry total

Source: Annual Report of the Ministry of Industry, Science and Technology Under the Corporations and Labour
Unions Resources Act, Industry Canada, March 1990, p. 94. Reproduced with the permission of the Minister
of Public Works and Government Services Canada, 2001.
*As measured by total revenue.

pure monopolist has no rivals at all. Yet, for two reasons the monopolistic competi-
tor’s demand is not perfectly elastic like that of the pure competitor. First, the
monopolistic competitor has fewer rivals; second, its products are differentiated, so
they are not perfect substitutes.
The price elasticity of demand faced by the monopolistically competitive firm
depends on the number of rivals and the degree of product differentiation. The
larger the number of rivals and the weaker the product differentiation, the greater
the price elasticity of each seller’s demand; that is, the closer monopolistic compe-
tition will be to pure competition.

The Short Run: Profit or Loss

The monopolistically competitive firm maximizes its profit or minimizes its loss in the
short run just as the other firms we have discussed do: by producing the output at
which marginal revenue equals marginal cost (MR = MC). In Figure 11-2(a) the firm
produces output Q1, where MR = MC. As shown by demand curve D1, the firm then can
charge price P1. It realizes an economic profit, shown by the grey area [= (P1 – A1) × Q1].
But with less favourable demand or costs, the firm may incur a loss in the short
run. We show this possibility in Figure 11-2(b), where the firm’s best strategy is to
minimize its loss. It does so by producing output Q2 (where MR = MC) and, as deter-
mined by demand curve D2, by charging price P2. Because price P2 is less than aver-
age total cost A2, the firm incurs a per unit loss of A2 – P2 and a total loss represented
as the pink area [= (A2 – P2) × Q2].
278 Part Two • Microeconomics of Product Markets

The Long Run: Only a Normal Profit

In the long run, firms will enter a profitable monopolistically competitive industry
and leave an unprofitable one. So, a monopolistic competitor will earn only a nor-
mal profit in the long run. (Remember that the costs curves include both explicit and
implicit costs, including a normal profit.)

PROFITS: FIRMS ENTER

In the case of short-run profit in Figure 11-2(a), economic profits attract new rivals
because entry to the industry is relatively easy. As new firms enter, the demand
curve faced by the typical firm shifts to the left (falls). Why? Because each firm has
a smaller share of total demand and now faces a larger number of close-substitute
products. This decline in the firm’s demand reduces its economic profit. When entry
of new firms has reduced demand to the extent that the demand curve is tangent to
the average-total-cost curve at the profit-maximizing output, the firm is just mak-
ing a normal profit. This situation is shown in Figure 11-2(c), where demand is D3
and the firm’s long-run equilibrium output is Q3. As Figure 11-2(c) indicates, any
greater or lesser output will entail an average total cost that exceeds product price
P3, meaning a loss for the firm. At the tangency point between the demand curve
and ATC, total revenue equals total costs. With the economic profit gone, no further
incentive exists for additional firms to enter.

LOSSES: FIRMS LEAVE

When the industry suffers short-run losses, as in Figure 11-2(b), some firms will exit
in the long run. Faced with fewer substitute products and blessed with an expanded
share of total demand, the surviving firms will see their demand curves shift to the
right (rise), as to D3. Their losses will disappear and give way to normal profits,
shown in Figure 11-2(c). (For simplicity we have assumed constant costs; shifts in
the cost curves as firms enter or leave would complicate our discussion slightly but
would not alter our conclusions.)

COMPLICATIONS
The representative firm in the monopolistic competition model earns only a normal
profit in the long run. That outcome may not always occur, however, in the real
world of small firms as opposed to the theoretical model.
● Some firms may achieve sufficient product differentiation that other firms can-
not duplicate them, even over time. One hotel in a major city may have the best
location relative to business and tourist activities. Or a firm may have devel-
oped a well-known brand name that gives it a slight but very long-lasting
advantage over imitators. Such firms may have sufficient monopoly power to
realize modest economic profits even in the long run.
● Entry to some monopolistically competitive industries is not as free in reality
as it is in theory. Because of product differentiation, greater financial barriers
to entry are likely to exist than if the product were standardized. This suggests
some monopoly power, with small economic profits continuing even in the
long run.
With all things considered, however, the normal profit outcome—the long-run equi-
librium—shown in Figure 11-2(c) is a reasonable portrayal of reality.
 chapter eleven • monopolistic competition and oligopoly 279

Key Graph FIGURE 11-2 A MONOPOLISTICALLY COMPETITIVE

FIRM: SHORT RUN AND LONG RUN
MC ATC The monopolistic competitor maximizes profit or minimizes
loss by producing the output at which MR = MC. The eco-

Price and costs

nomic profit shown in panel (a) will induce new firms to
P1
enter, eventually eliminating economic profit. The loss
A1 D1
shown in panel (b) will cause an exit of firms until normal
Economic profit is restored. After such entry and exit, the price will
profit
MR = MC MR settle in panel (c) to where it just equals average total cost
at the MR = MC output. At this price P3 and output Q3, the
0 Q1 monopolistic competitor earns only a normal profit, and the
Quantity industry is in long-run equilibrium.
(a) Short-run profits

MC ATC
ATC MC
Price and costs

Price and costs

A2
P3 =
P2 A3
Loss D2 D3

MR = MC MR MR = MC MR

0 Q2 0 Q3
Quantity Quantity
(b) Short-run losses (c) Long-run equilibrium

Quick Quiz
1. Price exceeds MC in
a. graph (a) only.
b. graph (b) only.
c. graphs (a) and (b) only.
d. graphs (a), (b), and (c).
2. Price exceeds ATC in
a. graph (a) only.
b. graph (b) only.
c. graphs (a) and (b) only.
d. graphs (a), (b), and (c).
3. The firm represented by Figure 11-2(c) is
a. making a normal profit.
b. incurring a loss, once opportunity costs are considered.
c. producing at the same level of output as a purely competitive firm.
d. producing a standardized product.
4. Which of the following pairs are both competition-like elements in mon-
opolistic competition?
a. Price exceeds MR; standardized product.
b. Entry is relatively easy; only a normal profit in the long run.
c. Price equals MC at the profit-maximizing output; economic profits are likely in
the long run.
d. The firms’ demand curve is downsloping; differentiated products.
Answers
1. d; 2. a; 3. a; 4. b
280 Part Two • Microeconomics of Product Markets

Monopolistic Competition and Efficiency

We know from Chapter 9 that economic efficiency requires the triple equality P =
MC = minimum ATC. The equality of price and minimum average total cost yields
productive efficiency. The good is being produced in the least costly way, and the price
is just sufficient to cover average total cost, including a normal profit. The equality
of price and marginal cost yields allocative efficiency. The right amount of output is
being produced, and thus the right amount of society’s scarce resources is being
devoted to this specific use.
How efficient is monopolistic competition, as measured against this triple equality?

Neither Productive nor Allocative Efficiency

In monopolistic competition, neither productive nor allocative efficiency is achieved
in long-run equilibrium. We show this in Figure 11-3, which includes an enlarge-
ment of part of Figure 11-2(c). First note that the profit-maximizing price P3 slightly
exceeds the lowest average total cost, A4. Therefore, in producing the profit-maxi-
mizing output Q3, the firm’s average total cost is slightly higher than optimal from
society’s perspective—productive efficiency is not achieved. Also note that the
profit-maximizing price P3 exceeds marginal cost (here M3), meaning that monopo-
listic competition causes an underallocation of resources. Society values each unit

FIGURE 11-3 THE INEFFICIENCY OF MONOPOLISTIC COMPETITION

MC

MC ATC P3 = A3
ATC
Price and costs

A4
P3 = A3
D3
D3

MR M3
MR = MC

0 Q3 Q4 MR
Quantity Q3 Q4

Excess capacity
In long-run equilibrium a monopolistic competitor achieves neither productive nor allocative efficiency. Productive efficiency
is not realized because production occurs where the average total cost A3 exceeds the minimum average total cost A4.
Allocative efficiency is not realized because the product price P3 exceeds the marginal cost M3. The result is an underalloca-
tion of resources and excess productive capacity of Q4 – Q3.
 chapter eleven • monopolistic competition and oligopoly 281

of output between Q3 and Q4 more highly than the goods it would have to forgo to
produce those units. Thus, to a modest extent, monopolistic competition also fails
the allocative-efficiency test. Consumers pay a higher-than-competitive price and
obtain a less-than-optimal output. Indeed, monopolistic competitors must charge a
higher-than-competitive price in the long run to achieve a normal profit.

Excess Capacity
In monopolistic competition, the gap between the minimum-ATC output and the
excess profit-maximizing output identifies excess capacity: plant or equipment that is
capacity Plant underused because firms are producing less than the minimum-ATC output. We
or equipment that is show this gap as the distance between Q4 and Q3 in Figure 11-3. If each monopolis-
underused because
the firm is produc-
tic competitor could profitably produce at the minimum-ATC output, fewer firms
ing less than the could produce the same total output, and the product could be sold at a lower price.
minimum-ATC Monopolistically competitive industries thus are overcrowded with firms, each
output. operating below its optimal capacity. This situation is typified by many kinds of
retail establishments. For example, most cities have an abundance of small motels
and restaurants that operate well below half capacity. (Key Question 2)

Product Variety
The situation portrayed in Figures 11-2(c) and 11-3 is not very satisfying to monop-
olistic competitors, since it foretells only a normal profit. But the profit-realizing
firm of Figure 11-2(a) need not stand by and watch new competitors eliminate its
profit by imitating its product, matching its customer service, and copying its adver-
tising. Each firm has a product that is distinguishable in some way from those of the
other producers. So, the firm can attempt to stay ahead of competitors and sustain
its profit through further product differentiation and better advertising. By devel-
oping or improving its product, it may be able to postpone, at least for a while, the
outcome of Figure 11-2(c).
It is true that product differentiation and advertising will add to the firm’s costs,
but they can also increase the demand for its product. If demand increases by more
than enough to compensate for the added costs, the firm will have improved its
profit position. As Figure 11-3 suggests, the firm has little or no prospect of increas-
ing profit by price-cutting. So why not engage in nonprice competition?

Benefits of Product Variety

The product variety and product improvement that accompany the drive to main-
tain economic profit in monopolistic competition are a benefit for society—ones that
may offset the cost of the inefficiency associated with monopolistic competition.
Consumers have a wide diversity of tastes: Some like regular fries, others like curly
fries; some like contemporary furniture, others like traditional furniture. If a prod-
uct is differentiated, then at any time the consumer will be offered a wide range of
types, styles, brands, and quality gradations of that product. Compared with pure
competition, this provides an advantage to the consumer. The range of choice is
widened, and producers more fully meet the wide variation in consumer tastes.
The product improvement promoted by monopolistic competition further dif-
ferentiates products and expands choices, and a successful product improvement by
one firm obligates rivals to imitate or improve on that firm’s temporary market
advantage or else lose business. So, society benefits from better products.
282 Part Two • Microeconomics of Product Markets

In fact, product differentiation creates a tradeoff between consumer choice and

productive efficiency. The stronger the product differentiation, the greater is the
excess capacity and, hence, the greater is the productive inefficiency. But the greater
the product differentiation, the more likely the firms will satisfy the great diversity
of consumer tastes. The greater is the excess capacity problem, the wider the range
of consumer choice.

Further Complexity
Finally, the ability to engage in nonprice competition makes the market situation of
a monopolistic competitor more complex than Figure 11-3 indicates. That figure
assumes a given (unchanging) product and a given level of advertising expendi-
tures. But we know that, in practice, product attributes and advertising are not
fixed. The monopolistically competitive firm juggles three factors—price, product,
and advertising—in seeking maximum profit. It must determine what variety of
product, selling at what price, and supplemented by what level of advertising will
result in the greatest profit. This complex situation is not easily expressed in a
simple, meaningful economic model. At best, we can say that each possible combi-
nation of price, product, and advertising poses a different demand and cost (pro-
duction cost plus advertising cost) situation for the firm, and that only one
combination yields the maximum profit. In practice, this optimal combination can-
not be readily forecast but must be found by trial and error.

● Monopolistic competition involves a relatively
large number of firms operating in a noncollu-
sive way and producing differentiated products,
with easy industry entry and exit.
● In the short run, a monopolistic competitor will
maximize profit or minimize loss by producing
that output at which marginal revenue equals
marginal cost.
● In the long run, the easy entry and exit of firms
cause monopolistic competitors to earn only a
normal profit
● A monopolistic competitor’s long-run equilibrium
output is such that price exceeds the minimum
average total cost (implying that consumers do
not get the product at the lowest price attainable)
and price exceeds marginal cost (indicating that
resources are underallocated to the product).

Oligopoly
In terms of competitiveness, the spectrum of market structures reaches from pure
competition to monopolistic competition, to oligopoly, to pure monopoly (review
oligopoly A Table 9-1). We now direct our attention to oligopoly, a market dominated by a few
market structure large producers of a homogeneous or differentiated product. Because of their small
dominated by a number, oligopolists have considerable control over their prices, but each must
few large producers
of homogeneous
consider the possible reaction of rivals to its own pricing, output, and advertising
or differentiated decisions.
products.
A Few Large Producers
The phrase “a few large producers” is necessarily vague because the market model
of oligopoly covers much ground, ranging between pure monopoly on the one
 chapter eleven • monopolistic competition and oligopoly 283

hand, and monopolistic competition on the other. Oligopoly encompasses the Cana-
dian steel industry, in which two firms dominate an entire national market, and the
situation in which four or five much smaller auto parts stores enjoy roughly equal
<www.indiana.edu/ shares of the market in a medium-sized town. Generally, however, when you hear
~econed/pdffiles/ a term such as Big Three, Big Four, or Big Six, you can be sure it refers to an oligop-
fall99/meister.pdf> olistic industry.
Oligopoly: An in-class
economic game
Homogeneous or Differentiated Products
homoge- An oligopoly may be either a homogeneous oligopoly or a differentiated oligopoly,
neous depending on whether the firms in the oligopoly produce standardized or differen-
oligopoly An tiated products. Many industrial products (steel, zinc, copper, aluminum, lead,
oligopoly in which
the firms produce cement, industrial alcohol) are virtually standardized products that are produced in
a standardized oligopolies. Alternatively, many consumer goods industries (automobiles, tires,
product. household appliances, electronics equipment, breakfast cereals, cigarettes, and many
sporting goods) are differentiated oligopolies. These differentiated oligopolies typi-
differen- cally engage in considerable nonprice competition supported by heavy advertising.
tiated
oligopoly An
oligopoly in which Control over Price, but Mutual Interdependence
the firms produce
a differentiated Because firms are few in oligopolistic industries, each firm is a price-maker; like the
product. monopolist, it can set its price and output levels to maximize its profit. But unlike
the monopolist, which has no rivals, the oligopolist must consider how its rivals will
react to any change in its price, output, product characteristics, or advertising. Oli-
mutual gopoly is thus characterized by mutual interdependence: a situation in which each
interde- firm’s profit depends not entirely on its own price and sales strategies but also on
pendence A those of its rivals. For example, in deciding whether to increase the price of its rolled
situation in which a
change in strategy
steel, Dofasco will try to predict the response of the other major producer, Stelco,
(usually price) by both located in Hamilton, Ontario. In deciding on its advertising strategy, Burger
one firm will affect King will take into consideration how McDonald’s might react.
the sales and profits
of other firms.
Entry Barriers
The same barriers to entry that create pure monopoly also contribute to the creation
of oligopoly. Economies of scale are important entry barriers in a number of oli-
gopolistic industries, such as the aircraft, rubber, and cement industries. In those
industries, three or four firms might each have sufficient sales to achieve economies
of scale, but new firms would have such a small market share that they could not
do so. They would then be high-cost producers, and as such they could not survive.
A closely related barrier is the large expenditure for capital—the cost of obtaining
necessary plant and equipment—required for entering certain industries. The auto-
mobile, commercial aircraft, and petroleum-refining industries, for example, are all
characterized by very high capital requirements.
The ownership and control of raw materials help explain why oligopoly exists in
many mining industries, including gold, silver, and copper. In the electronics, chem-
icals, photographic equipment, office machine, and pharmaceutical industries,
patents have served as entry barriers. Oligopolists can also preclude the entry of new
competitors through preemptive and retaliatory pricing and advertising strategies.

Mergers
Some oligopolies have emerged mainly through the growth of the dominant firms
in a given industry (breakfast cereals, chewing gum, candy bars). But for other
284 Part Two • Microeconomics of Product Markets

industries the route to oligopoly has been through mergers (examples: steel, in its
early history; and, more recently, airlines, banking, and entertainment). The merg-
ing, or combining, of two or more competing firms may substantially increase their
market share, which in turn may allow the new firm to achieve greater economies
of scale.
<distance- Another motive underlying the “urge to merge” is the desire for a greater degree
ed.bcc.ctc.edu/ of monopoly power. The larger firm that results from a merger has greater control
econ100/ksttext/
oligoply/oligoply.htm>
over market supply and thus the price of its product. Also, since it is a larger buyer
The arthritic hand of of inputs, it will probably be able to demand and obtain lower prices (costs) on its
oligopoly production inputs.

Measures of Industry Concentration

Several means are used to measure the degree to which oligopolistic industries are
concentrated in their largest firms. The most-often-used measures are concentration
ratios and the Herfindahl index.

CONCENTRATION RATIO
concentra- A concentration ratio reveals the percentage of total output produced and sold by
tion ratio an industry’s largest firms. Figure 11-4 lists the four-firm concentration ratio—the
The percentage of percentage of total industry sales accounted for by the four largest firms—for a
the total sales of an
industry produced
number of oligopolistic industries. For example, the four largest Canadian produc-
and sold by an ers of tobacco products manufacture almost 100 percent of all cigarettes produced
industry’s largest in Canada.
firms. When the largest four firms in an industry control 40 percent or more of the mar-
ket (as in Figure 11-4), that industry is considered oligopolistic. Using this bench-
mark, about one-half of all Canadian manufacturing industries are oligopolies.
Although concentration ratios provide useful insights into the competitiveness or
monopoly power of various industries, they have three shortcomings.

FIGURE 11-4 PERCENTAGE OF OUTPUT PRODUCED BY

THE FOUR LARGEST FIRMS IN SELECTED HIGH-
CONCENTRATION INDUSTRIES*

Tobacco products
Motor vehicles
Petroleum and
coal products
Primary metals
Beverages
Metal mining
Rubber products
0 20 40 60 80 100
Percentage of industry total
Source: Douglas West, Modern Canadian Industrial Organization, HarperCollins, 1994, p. 37.
*As measured by dollar value of shipments
 chapter eleven • monopolistic competition and oligopoly 285

ONE: LOCALIZED MARKETS

Concentration ratios pertain to the nation as a whole, whereas the markets for some
products are highly localized because of high transportation costs. For example, the
four-firm concentration ratio for concrete products is only 23 percent, suggesting a
competitive industry in Canada. But the sheer bulk of this product limits the rele-
vant market to a specific town or metropolitan area, and in such localized markets
we often find oligopolistic concrete producers.

TWO: INTERINDUSTRY COMPETITION

Since definitions of industries are somewhat arbitrary, we must be aware of
inter- interindustry competition—that is, competition between two products associated
industry with different industries. The high concentration ratio for the primary metals shown
competition in Figure 11-4 understates the competition in that industry, because aluminum com-
The competition
between the prod- petes with copper in many applications (for example, in the market for electrical
ucts of one industry transmission lines).
and the products of
another industry. THREE: WORLD TRADE
The data in Figure 11-4 are for products produced in Canada only and may overstate
import concentration because they do not account for the import competition of foreign
competition suppliers. The automobile industry is a good example. Although Figure 11-4 shows
The competition that three firms produce over 90 percent of the domestic output of those goods, it
domestic firms
encounter from ignores the fact that a large portion of the automobiles bought in Canada are
the products and imports. Many of the world’s largest corporations are foreign, and many of them do
services of foreign business in Canada.
producers.
Herfindahl Index
The shortcomings of concentration ratios listed above actually apply to many meas-
ures of concentration, but one of those shortcomings can be eliminated: Suppose
that in industry X one firm produces all the market output. A second industry, Y, has
<reinsurance.home. four firms, of which each has 25 percent of the market. The concentration ratio is 100
mindspring.com/
percent for both these industries. But industry X is a pure monopoly, while indus-
mktconc.htm>
Using the Herfindahl try Y is an oligopoly that may be facing significant economic rivalry. Most econo-
Index to Measure mists would agree that monopoly power (or market power) is substantially greater
Industry Concentration in industry X than in industry Y, a fact disguised by their identical 100 percent con-
centration ratios.
herfindahl The Herfindahl index addresses this problem. This index is the sum of the
index The sum squared percentage market shares of all firms in the industry. In equation form:
of the squared per-
centage market Herfindahl index = (%S1)2 + (%S2)2 + (%S3)2 + … + (%Sn)2
shares of all firms
in the industry. where %S1 is the percentage market share of firm 1, %S2 is the percentage market
share of firm 2, and so on for each firm in the industry. By squaring the percentage
market shares of all firms in the industry, the Herfindahl index gives much greater
weight to larger, and thus more powerful, firms than to smaller ones. In the case of
the single-firm industry X, the index would be at its maximum of 1002 or 10,000,
indicating an industry with complete monopoly power. For our supposed four-firm
industry Y, the index would be 252 + 252 + 252 + 252, or 2500, indicating much less
market power. (For a purely competitive industry, the index would approach zero,
since each firm’s market share—%S in the equation—is extremely small.) To gener-
alize, the larger the Herfindahl index, the greater the market power within an
industry. (Key Question 7)
286 Part Two • Microeconomics of Product Markets

Oligopoly Pricing Behaviour:

A Game Theory Overview
Oligopoly pricing behaviour has the characteristics of certain games of strategy, such
as poker, chess, and bridge. The best way to play such a game depends on the way
one’s opponent plays. Players (and oligopolists) must pattern their actions according
to the actions and expected reactions of rivals. The study of how people behave in
game theory strategic situations is called game theory. We will use a simple game theory model to
model A means analyze the pricing behaviour of oligopolists. We assume a duopoly, or two-firm oli-
of analyzing the gopoly, producing athletic shoes. Each firm—let’s call them RareAir and Uptown—
pricing behaviour of
oligopolists using
has a choice of two pricing strategies: price high or price low. The profit each firm
the theory of strat- earns will depend on the strategy it chooses and the strategy its rival chooses.
egy associated Four combinations of strategies are possible for the two firms, and a lettered cell
with games such as in Figure 11-5 represents each combination. For example, cell C represents a low-
chess and bridge. price strategy for Uptown along with a high-price strategy for RareAir. Figure 11-5
is called a payoff matrix because each cell shows the payoff (profit) to each firm that
would result from each combination of strategies. Cell C shows that if Uptown
adopts a low-price strategy and RareAir a high-price strategy, then Uptown will
earn $15 million (green portion) and RareAir will earn $6 million (orange portion).

Mutual Interdependence Revisited

The data in Figure 11-5 are hypothetical, but their relationships are typical of real sit-
uations. Recall that oligopolistic firms can increase their profits, and influence their
rivals’ profits, by changing their pricing strategies. Each firm’s profit depends on its
own pricing strategy and that of its rivals. This mutual interdependence of oligop-
olists is the most obvious point demonstrated by Figure 11-5. If Uptown adopts a
high-price strategy, its profit will be $12 million, provided that RareAir also employs
a high-price strategy (cell A). But if RareAir uses a low-price strategy against

FIGURE 11-5 PROFIT PAYOFF (IN MILLIONS) FOR A TWO-FIRM

OLIGOPOLY
Each firm has two RareAir's price strategy
possible pricing
strategies. RareAir’s
High Low
strategies are shown
in the top margin, and
Uptown’s in the left A $12 B $15
margin. Each lettered
Uptown's price strategy

High
cell of this four-cell
payoff matrix repre-
sents one combina- $12 $6
tion of a RareAir
strategy and an
Uptown strategy and
C $6 D $8
shows the profit that
combination would Low
earn for each firm.
$15 $8
 chapter eleven • monopolistic competition and oligopoly 287

Uptown’s high-price strategy (cell B), RareAir will increase its market share and
boost its profit from $12 to $15 million. RareAir’s higher profit will come at the
expense of Uptown, whose profit will fall from $12 to $6 million. Uptown’s high-
price strategy is a good strategy only if RareAir also employs a high-price strategy.

Collusive Tendencies
collusion Figure 11-5 also suggests that oligopolists often can benefit from collusion—that is,
A situation in which cooperation with rivals. To see the benefits of collusion, first suppose that both firms
firms act together in Figure 11-5 are acting independently and following high-price strategies. Each
and in agreement
to fix prices, divide
realizes a $12 million profit (cell A).
a market, or Note that either RareAir or Uptown could increase its profit by switching to a low-
otherwise restrict price strategy (cell B or C). The low-price firm would increase its profit to $15 million,
competition. and the high-price firm’s profit would fall to $6 million. The high-price firm would be
better off if it, too, adopted a low-price policy, Doing so would increase its profit from
$6 million to $8 million (cell D). The effect of all this independent strategy shifting
would be to reduce both firms’ profits from $12 million (cell A) to $ 8 million (cell D).
In real situations, too, independent action by oligopolists may lead to mutual
competitive low-price strategies: Independent oligopolists compete with respect to
price, which leads to lower prices and lower profits. This is clearly beneficial to con-
sumers but not to the oligopolists whose profits decrease.
How could oligopolists avoid the low-profit outcome of cell D? The answer is that
they could collude, rather than establish prices competitively or independently. In
our example, the two firms could agree to establish and maintain a high-price pol-
icy. Each firm will increase its profit from $8 million (cell D) to $12 million (cell A).

Incentive to Cheat
The payoff matrix also explains why an oligopolist might be strongly tempted to
cheat on a collusive agreement. Suppose Uptown and RareAir agree to maintain
high-price policies, with each earning $12 million in profit (cell A). Both are tempted
to cheat on this collusive pricing agreement, because either firm can increase its
profit to $15 million by lowering its price. If Uptown secretly cheats on the agree-
ment by charging low prices, the payoff moves from cell A to cell C. Uptown’s profit
rises to $15 million, and RareAir’s falls to $6 million. If RareAir cheats, the payoff
moves from cell A to cell B, and RareAir gets the $15 million. (Key Question 8)

● An oligopoly is made up of relatively few firms
producing either homogeneous or differentiated
products; these firms are mutually interdependent.
● Barriers to entry such as scale economies, con-
trol of patents or strategic resources, or the abil-
ity to engage in retaliatory pricing characterize
oligopolies. Oligopolies may result from inter-
nal growth of firms, mergers, or both.
● The four-firm concentration ratio shows the per-
centage of an industry’s sales accounted for
by its four largest firms; the Herfindahl index
measures the degree of market power in an
industry by summing the squares of the per-
centage market shares held by the individual
firms in the industry.
● Game theory reveals that (1) oligopolies are
mutually interdependent in their pricing poli-
cies, (2) collusion enhances oligopoly profits,
and (3) there is a temptation for oligopolists to
cheat on a collusive agreement.
288 Part Two • Microeconomics of Product Markets

Three Oligopoly Models

To gain further insight into oligopolistic pricing and output behaviour, we will
examine three distinct pricing models: (1) the kinked-demand curve, (2) collusive
pricing, and (3) price leadership.
Why not a single model as in our discussions of the other market structures?
There are two reasons:
1. Diversity of oligopolies Oligopoly encompasses a greater range and diversity
of market situations than other market structures, including the tight oligopoly,
in which two or three firms dominate an entire market, and the loose oligopoly,
in which six or seven firms share, say, 70 or 80 percent of a market while a com-
petitive fringe of firms shares the remainder. Oligopoly includes both differenti-
ated and standardized products. It includes cases in which firms act in collusion
and those in which they act independently. It embodies situations in which bar-
riers to entry are very strong and situations in which they are not quite so strong.
In short, the diversity of oligopoly does not allow us to explain all oligopolistic
behaviours with a single market model.
2. Complications of interdependence The mutual interdependence of oligopolis-
tic firms complicates matters significantly. Because firms cannot predict the reac-
tions of their rivals with certainty, they cannot estimate their own demand and
marginal-revenue data. Without such data, firms cannot determine their profit-
maximizing price and output, even in theory, as we will see.
Despite these analytical difficulties, two interrelated characteristics of oligopolistic
pricing have been observed. First, if the macroeconomy is generally stable, oligop-
olistic prices are typically inflexible (or rigid or sticky). Prices change less fre-
quently under oligopoly than under pure competition, monopolistic competition,
and, in some instances, pure monopoly. Second, when oligopolistic prices do
change, firms are likely to change their prices together, suggesting a tendency to act
in concert, or collusively, in setting and changing prices (as we mentioned in the pre-
ceding section). The diversity of oligopolies and the presence of mutual interde-
pendence are reflected in the models that follow.

Kinked-Demand Theory: Noncollusive Oligopoly

Imagine an oligopolistic industry made up of three firms, Arch, King, and Dave’s,
each having about one-third of the total market for a differentiated product. Assume
that the firms are independent, meaning that they do not engage in collusive price
practices. Assume, too, that the going price for Arch’s product is P0 and its current
sales are Q0, as shown in Figure 11-6(a) (Key Graph).
Now the question is, “What does the firm’s demand curve look like?” Mutual
interdependence and the uncertainty about rivals’ reactions make this question hard
to answer. The location and shape of an oligopolist’s demand curve depend on how
the firm’s rivals will react to a price change introduced by Arch. Two plausible
assumptions can be made about the reactions of Arch’s rivals:
● Match price changes One possibility is that King and Dave’s will exactly
match any price change initiated by Arch. In this case, Arch’s demand and
marginal-revenue curves will look like the straight lines labelled D1 and MR1
in Figure 11-6(a). Why are they so steep? If Arch cuts its price, its sales will
increase only modestly, because its two rivals will also cut their prices to pre-
vent Arch from gaining an advantage over them. The small increase in sales
 chapter eleven • monopolistic competition and oligopoly 289

Key Graph FIGURE 11-6 THE KINKED-DEMAND CURVE

Rivals ignore
price increase
D2

Price and costs

e e
P0 P0 MR2 MC1
Price

f D2 f
MC2

Rivals match MR2 g

price decrease g
D1
D1

0 Q0 0 Q0
MR1 MR1
Quantity Quantity
(a) (b)
Panel (a): The slope of a noncollusive oligopolist’s demand and marginal-revenue curves depends on whether the firm’s
rivals match (straight lines D1 and MR1) or ignore (straight lines D2 and MR2) any price changes that it may initiate from
the current price P0. Panel (b): In all likelihood an oligopolist’s rivals will ignore a price increase but follow a price cut.
This reaction causes the oligopolist’s demand curve to be kinked (D2eD1) and the marginal-revenue curve to have a verti-
cal break, or gap (fg). Because any shift in marginal costs between MC1 and MC2 will cut the vertical (dashed) segment
of the marginal-revenue curve, no change in either price P0 or output Q0 will result from such a shift.

Quick Quiz
1. Suppose Q0 in this figure represents annual sales of five million units for
this firm. The other two firms in this three-firm industry sell three mil-
lion and two million units. The Herfindahl index for this industry is
a. 100 percent. c. 10.
b. 400. d. 3800.
2. The D2e segment of the demand curve D2eD1 in graph (b) implies that
a. this firm’s total revenue will fall if it increases its price above P0.
b. other firms will match a price increase above P0.
c. the firm’s relevant marginal-revenue curve will be MR1 for price increases
above P0.
d. the product in this industry is necessarily standardized.
3. By matching a price cut, this firm’s rivals can
a. increase their market shares.
b. increase their marginal revenues.
c. maintain their market shares.
d. lower their total costs.
4. A shift of the marginal-cost curve from MC2 to MC1 in graph (b) would
a. increase the going price above P0.
b. leave price at P0 but reduce this firm’s total profit.
c. leave price at P0 but reduce this firm’s total revenue.
d. make this firm’s demand curve more elastic.
Answers
1. d; 2. a; 3. c; 4. b
 290 Part Two • Microeconomics of Product Markets

that Arch (and its two rivals) will realize is at the expense of other industries;
Arch will gain no sales from King and Dave. If Arch raises its price, its sales
will fall only modestly, because King and Dave’s will match its price increase.
The industry will lose sales to other industries, but Arcg will lose no customers
to King and Dave’s.
● Ignore price changes The other possibility is that King and Dave’s will ignore
any price change by Arch. In this case, the demand and marginal-revenue
curves faced by Arch will resemble the straight lines D2 and MR2 in Figure
11-6(a). Demand in this case is considerably more elastic than under the pre-
vious assumption. The reasons are clear: If Arch lowers its price and its rivals
do not, Arch will gain sales significantly at the expense of its two rivals,
because it will be underselling them. Conversely, if Arch raises its price and its
rivals do not, Arch will lose many customers to King and Dave’s, which will
be underselling it. Because of product differentiation, however, Arch’s sales
will not fall to zero when it raises its price; some of Arch’s customers will pay
the higher price because they have a strong preference for Arch’s product.

A COMBINED STRATEGY
Now, which is the most logical assumption for Arch to make about how its rivals
will react to any price change it might initiate? The answer is “it depends on the
direction of price.” Common sense and observation of oligopolistic industries sug-
gest that a firm’s rivals will match price declines below P0 as they act to prevent the
price-cutter from taking their customers. But the rivals will ignore price increases
above P0, because the rivals of the price-increasing firm stand to gain the business
lost by the price-booster. In other words, the dark blue left-hand segment of the
“rivals ignore” demand curve D2 seems relevant for price increases, and the dark
<www.hindubusiness blue right-hand segment of the “rivals match” demand curve D1 in Figure 11-6(a)
line.com/iw/2000/07/30/ seems relevant for price cuts. It is logical, then, or at least a reasonable assumption,
stories/0530e053.htm>
Herfindahl Index—
that the noncollusive oligopolist faces the kinked-demand curve D2eD1, as shown
Measuring industry in Figure 11-6(b). Demand is highly elastic above the going price P0 but much less
concentration elastic or even inelastic below that price.
Note also that if it is correct to suppose that rivals will follow a price cut but
kinked- ignore an increase, the marginal-revenue curve of the oligopolist will also have an
demand odd shape. It, too, will be made up of two segments: the purple left-hand part
curve The of marginal-revenue curve MR2 in Figure 11-6(a) and the purple right-hand part
demand curve for a
noncollusive oligop-
of marginal-revenue curve MR1. Because of the sharp difference in elasticity of
olist, that is based demand above and below the going price, there is a gap, or what we can simply
on the assumption treat as a vertical segment, in the marginal-revenue curve. We show this gap as
that rivals will fol- the dashed segment in the combined marginal-revenue curve MR2fgMR1 in Fig-
low a price decrease ure 11-6(b).
and will not follow a
price increase.
PRICE INFLEXIBILITY
This analysis helps to explain why prices are generally stable in noncollusive oli-
gopolistic industries; there are both demand and cost reasons.
On the demand side, the kinked-demand curve gives each oligopolist reason to
believe that any change in price will be for the worse. If it raises its price, many of
its customers will desert it. If it lowers its price, its sales at best will increase very
modestly, since rivals will match the lower price. Even if a price cut increases the oli-
gopolist’s total revenue somewhat, its costs may increase by a greater amount. And
if its demand is inelastic to the right of Q0, as it may well be, then the firm’s profit
 chapter eleven • monopolistic competition and oligopoly 291

will surely fall. A price decrease in the inelastic region lowers the firm’s total rev-
enue, and the production of a larger output increases its total costs.
On the cost side, the broken marginal-revenue curve suggests that even if an oli-
gopolist’s costs change substantially, the firm may have no reason to change its
price. In particular, all positions of the marginal-cost curve between MC1 and MC2
in Figure 11-6(b) will result in the firm’s deciding on exactly the same price and out-
put. For all those positions, MR equals MC at output Q0; at that output, the firm will
charge price P0.

CRITICISMS OF THE MODEL

The kinked-demand analysis has two shortcomings. First, it does not explain how
the going price gets to be at P0 in Figure 11-6 in the first place. It only helps explain
why oligopolists tend to stick with an existing price. The kinked-demand curve
explains price inflexibility but not price itself.
Second, when the macroeconomy is unstable, oligopoly prices are not as rigid as
the kinked-demand theory implies. During inflationary periods, many oligopolists
have raised their prices often and substantially. And during downturns (reces-
sions), some oligopolists have cut prices. In some instances these price reductions
price war have set off a price war: successive and continuous rounds of price cuts by rivals as
Successive and con- they attempt to maintain their market shares. (Key Question 9)
tinuous rounds of
price cuts by rivals
as they attempt to Cartels and Other Collusion
maintain their
market shares.
Our game theory model demonstrates that oligopoly is conducive to collusion. We
can say that collusion occurs whenever firms in an industry reach an agreement to
fix prices, divide up the market, or otherwise restrict competition among them-
selves. The disadvantages and uncertainties of noncollusive, kinked-demand oli-
gopolies are obvious. The danger always exists that a price war may break out,
especially during a general business recession. Then each firm finds that, because of
unsold goods and excess capacity, it can reduce per-unit costs by increasing market
share. Then, too, a new firm may surmount entry barriers and initiate aggressive
price-cutting to gain a foothold in the market. In addition, the kinked-demand
curve’s tendency toward rigid prices may adversely affect profits if general infla-
tionary pressures increase costs. However, by controlling price through collusion,
oligopolists may be able to reduce uncertainty, increase profits, and perhaps even
prohibit the entry of new rivals.

PRICE AND OUTPUT

Assume once again that there are three oligopolistic firms (Gypsum, Sheetrock, and
GSR) producing, in this instance, homogeneous products. All three firms have iden-
tical cost curves. Each firm’s demand curve is indeterminate unless we know how its
rivals will react to any price change. Therefore, we suppose each firm assumes that
its two rivals will match either a price cut or a price increase. In other words, each
firm has a demand curve like the straight line D1 in Figure 11-6(a). And, since they
have identical cost data, and the same demand and thus marginal-revenue data, we
can say that Figure 11-7 represents the position of each of our three oligopolistic firms.
What price and output combination should, say, Gypsum select? If Gypsum were
a pure monopolist, the answer would be clear: Establish output at Q0, where mar-
ginal revenue equals marginal cost, charge the corresponding price P0, and enjoy the
maximum profit attainable. However, firm Gypsum does have two rivals selling
identical products, and if Gypsum’s assumption that its rivals will match its price
292 Part Two • Microeconomics of Product Markets
FIGURE 11-7
If oligopolistic firms face
identical or highly similar
demand and cost condi-
tions, they may collude
to limit their joint output
and to set a single, com-
mon price. Thus each
firm acts as if it were a
pure monopolist, setting
output at Q0 and charg-
ing price P0. This price
and output combination
maximizes each oligopo-
list’s profit (grey area)
and thus their combined
or joint profit.
cartel A formal
agreement among
firms in an industry
to set the price of a
product and estab-
lish the outputs of
the individual firms
or to divide the mar-
ket among them.
COLLUSION AND THE TENDENCY TOWARD JOINT-
PROFIT MAXIMIZATION
MC
Price and costs
P0 ATC
A0
MR = MC
Economic
profit D
MR
0 Q0
Quantity
of P0 proves to be incorrect, the consequences could be disastrous for Gypsum.
Specifically, if Sheetrock and GSR actually charge prices below P0 then Gypsum’s
demand curve D will shift sharply to the left as its potential customers turn to its
rivals, which are now selling the same product at a lower price. Of course, Gypsum
can retaliate by cutting its price too, but this will move all three firms down their
demand curves, lowering their profits. It may even drive them to a point where
average total cost exceeds price and losses are incurred.
So the question becomes, Will Sheetrock and GSR want to charge a price below P0?
Under our assumptions, and recognizing that Gypsum has little choice except to match
any price they may set below P0, the answer is, No. Faced with the same demand and
cost circumstances, Sheetrock and GSR will find it in their interest to produce Q0 and
charge P0. This is a curious situation; each firm finds it most profitable to charge the
same price, P0, but only if its rivals actually do so! How can the three firms ensure the
price P0 and quantity Q0 solution in which each is keenly interested? How can they
avoid the less profitable outcomes associated with either higher or lower prices?
The answer is evident: They could collude. They could get together, talk it over, and
agree to charge the same price, P0. In addition to reducing the possibility of price wars,
this will give each firm the maximum profit. (But it will also subject them to anti-
combines prosecution if they are caught!) For society, the result will be the same as
would occur if the industry were a pure monopoly composed of three identical plants.
OVERT COLLUSION: THE OPEC CARTEL
Collusion may assume a variety of forms. The most comprehensive form of collu-
sion is the cartel, a group of producers that typically creates a formal written agreement
specifying how much each member will produce and charge. Output must be controlled—
the market must be divided up—to maintain the agreed-on price. The collusion is
overt, or open to view.
Undoubtedly the most significant international cartel is the Organization of
Petroleum Exporting Countries (OPEC), comprising 11 oil-producing nations (see
Global Perspective 11.1). OPEC produces 40 percent of the world’s oil and supplies
 chapter eleven • monopolistic competition and oligopoly 293

11.1

OPEC Country Barrels of Oil

The 11 OPEC
nations, daily oil Saudi Arabia 8,253,000
production, 2000 Iran 3,727,000

The OPEC nations produce Venezuela 2,926,000

about 40 percent of the United Arab 2,209,000
Emirates
world’s oil and 60 percent of
Nigeria 2,091,000
the oil sold in world markets.
Kuwait 2,037,000
Libya 1,361,000
Indonesia 1,317,000
Algeria 811,000
Qatar 658,000
Iraq (UN embargo)
Source: OPEC <www.opec.org>.

60 percent of all oil traded internationally. In the late 1990s OPEC reacted vigorously
to very low oil prices by greatly restricting supply. Some non-OPEC producers sup-
ported the cutback in production and within a 15-month period, the price of oil shot
up from $11 a barrel to $34 a barrel. Gasoline prices in Canada rose by as much as
50 percent in some markets. Fearing a global political and economic backlash from
the major industrial nations, OPEC upped the production quotas for its members in
mid-2000. The increases in oil supply that resulted reduced oil prices somewhat. It
is clear that the OPEC cartel has sufficient market power to hold the price of oil sub-
stantially above its marginal cost of production.

COVERT COLLUSION: RELATIVELY RECENT EXAMPLES

Cartels are illegal in Canada, and hence any collusion that exists is covert or secret.
Yet there are examples, as evidence from anti-combines (antimonopoly) cases. One
example of covert collusion is the case of four cement firms in the Quebec City
Region. In 1996 St. Lawrence Cement Inc., Lafarge Canada Inc., Cement Quebec Inc.,
and Beton Orleans Inc. were fined a total of $5.8 million for price fixing. A Quebec
City newspaper that reported that the cost of the city’s new convention centre was
higher than anticipated discovered the conspiracy. The first three of these firms had
previously been fined in 1983 for a similar violation of the Competition Act.
tacit under- In many other instances collusion is even subtler. Tacit understandings (histori-
standings cally called “gentlemen’s agreements”) are frequently made at cocktail parties, on
Any method by golf courses, through phone calls, or at trade association meetings. In such agree-
competing oligopo-
lists to set prices
ments, competing firms reach a verbal understanding on product price, leaving
and outputs that market shares to be decided by nonprice competition. Although these agreements,
does not involve too, violate anti-combines laws—and can result in severe personal and corporate
outright collusion. penalties—the elusive character of tacit understandings makes them more difficult
to detect.
294 Part Two • Microeconomics of Product Markets

OBSTACLES TO COLLUSION
Normally, cartels and similar collusive arrangements are difficult to establish and
maintain. We look now at several barriers to collusion.
Demand and Cost Differences When oligopolists face different costs and demand
curves, it is difficult for them to agree on a price, which is particularly true in indus-
tries where products are differentiated and change frequently. Even with highly
standardized products, firms usually have somewhat different market shares and
operate with differing degrees of productive efficiency. Thus, it is unlikely that even
homogeneous oligopolists would have the same demand and cost curves.
In either case, differences in costs and demand mean that the profit-maximizing
price will differ among firms; no single price will be readily acceptable to all, as we
assumed was true in Figure 11-7. So, price collusion depends on compromises and
concessions that are not always easy to obtain, and hence they act as obstacles to
collusion.
Number of Firms Other things being equal, the larger the number of firms, the more
difficult it is to create a cartel or other form of price collusion. Agreement on price
by three or four producers that control an entire market may be relatively easy to
accomplish, but such agreement is more difficult to achieve where there are, say, 10
firms, each with roughly 10 percent of the market, or where the Big Three have 70
percent of the market while a competitive fringe of 8 or 10 smaller firms battles for
the remainder.
Cheating As the game theory model makes clear, there is a temptation for collusive
oligopolists to engage in secret price cutting to increase sales and profit. The diffi-
culty with such cheating is that buyers who are paying a high price for a product
may become aware of the lower-priced sales and demand similar treatment. Or buy-
ers receiving a price concession from one producer may use the concession as a
wedge to get even larger price concessions from a rival producer. Buyers’ attempts
to play producers against one another may precipitate price wars among the pro-
ducers. Although secret price concessions are potentially profitable, they threaten
collusive oligopolies over time. Collusion is more likely to succeed when cheating
is easy to detect and punish. They, the conspirators are less likely to cheat on the
price agreement.
Recession Long-lasting recession usually serves as an enemy of collusion, because
slumping markets increase average total cost. In technical terms, as the oligopolists’
demand and marginal-revenue curves shift to the left in Figure 11-7 in response to
a recession, each firm moves leftward and upward to a higher operating point on
its average-total-cost curve. Firms find they have substantial excess production
capacity, sales are down, unit costs are up, and profits are being squeezed. Under
such conditions, businesses may feel they can avoid serious profit reductions (or
even losses) by cutting price and thus gaining sales at the expense of rivals.
Potential Entry The greater prices and profits that result from collusion may attract
new entrants, including foreign firms. Since that would increase market supply and
reduce prices and profits, successful collusion requires that colluding oligopolists
block the entry of new producers.
Legal Obstacles: Anti-Combines Law Canadian anti-combines laws prohibit cartels
and price-fixing collusion, so less obvious means of price control have evolved in
this country.
 chapter eleven • monopolistic competition and oligopoly 295

Price Leadership Model

price Price leadership is a type of implicit understanding by which oligopolists can
leadership coordinate prices without engaging in outright collusion based on formal agree-
An implicit under- ments and secret meetings. Rather, a practice evolves whereby the “dominant
standing oligopolists
use to coordinate firm”—usually the largest or most efficient in the industry—initiates price
prices without changes and all other firms more or less automatically follow the leader. Many
engaging in outright industries, including farm machinery, cement, newsprint, glass containers, steel,
collusion by having beer, fertilizer, cigarettes, and tin, are practising, or have in the recent past practised,
the dominant price leadership.
firm initiate price
changes and all
other firms follow.
LEADERSHIP TACTICS
An examination of price leadership in a variety of industries suggests that the price
leader is likely to use the following tactics.

Infrequent Price Changes Because price changes always carry the risk that rivals
will not follow the lead, price adjustments are made only infrequently. The price
leader does not respond to minuscule day-to-day changes in costs and demand.
Price is changed only when cost and demand conditions have been altered signifi-
cantly and on an industrywide basis as the result of, for example, industrywide
wage increases, an increase in excise taxes, or an increase in the price of some basic
input such as energy. In the automobile industry, price adjustments traditionally are
made when new models are introduced.

Communications The price leader often communicates impending price adjust-

ments to the industry through speeches by major executives, trade publication inter-
views, or press releases. By publicizing the need to raise prices, the price leader
seeks agreement among its competitors regarding the actual increase.

Limit Pricing The price leader does not always choose the price that maximizes
short-run profits for the industry because the industry may want to discourage new
firms from entering. If the cost advantages (economies of scale) of existing firms are
a major barrier to entry, new entrants could surmount that barrier if the price leader
and the other firms set product price high enough. New firms that are relatively
inefficient because of their small size might survive and grow if the industry sets
price very high. So, to discourage new competitors and to maintain the current oli-
gopolistic structure of the industry, the price leader may keep price below the short-
run profit-maximizing level. The strategy of establishing a price that blocks the
entry of new firms is called limit pricing.

Breakdowns in Price Leadership: Price Wars Price leadership in oligopoly occa-

sionally breaks down, at least temporarily, and sometimes results in a price war. An
example of disruption of price leadership occurred in the breakfast cereal industry,
in which Kellogg traditionally had been the price leader. General Mills countered
Kellogg’s leadership in 1995 by reducing the prices of its cereals by 11 percent. In
1996 Post responded with a 20 percent price cut, which Kellogg then followed. Not
to be outdone, Post reduced its prices by another 11 percent.
Most price wars eventually run their course. When all firms recognize that low
prices are severely reducing their profits, they again cede price leadership to one of
the industry’s leading firms. That firm then begins to raise prices, and the other
firms willingly follow suit.
296 Part Two • Microeconomics of Product Markets

● In the kinked-demand theory of oligopoly, price
is relatively inflexible because a firm contem-
plating a price change assumes that its rivals will
follow a price cut and ignore a price increase.
● Cartels agree on production limits and set a
common price to maximize the joint profit of
their members as if each were a unit of a single
pure monopoly.
● Collusion among oligopolists is difficult because
of (1) demand and cost differences among sell-
ers, (2) the complexity of output coordination
among producers, (3) the potential for cheating,
(4) a tendency for agreements to break down
during recessions, (5) the potential entry of new
firms, and (6) anti-combines laws.
● Price leadership involves an informal under-
standing among oligopolists to match any price
change initiated by a designated firm (often the
industry’s dominant firm).

Oligopoly and Advertising

We have noted that oligopolists would rather not compete on the basis of price and
may become involved in price collusion. Nonetheless, each firm’s share of the total
market is typically determined through product development and advertising, for
two reasons:
1. Product development and advertising campaigns are less easily duplicated than
price cuts. Price cuts can be quickly and easily matched by a firm’s rivals to can-
cel any potential gain in sales derived from that strategy. Product improvements
and successful advertising, however, can produce more permanent gains in mar-
ket share because they cannot be duplicated as quickly and completely as price
reductions.
2. Oligopolists have sufficient financial resources to engage in product develop-
ment and advertising. For most oligopolists, the economic profits earned in the
past can help finance current advertising and product development.
Product development (or, more broadly, research and development) is the subject
of the next chapter, so we will confine our present discussion to advertising. In re-
cent years, Canadian advertising has exceeded
$5 billion annually, and worldwide advertising,
TABLE 11-1 THE LARGEST $420 billion. Advertising is prevalent in both
CANADIAN monopolistic competition and oligopoly. Table
ADVERTISERS, 11-1 lists the five leading Canadian advertisers
2000 in 2000.
Advertising spending Advertising may affect prices, competition,
Company (millions of dollars) and efficiency both positively and negatively,
depending on the circumstances. While our
General Motors 165.0 focus here is on advertising by oligopolists, the
DaimlerChrysler 113.8 analysis is equally applicable to advertising by
Ford Motor Co. 103.1 monopolistic competitors.
Bell Canada Enterprises 65.4
Government of Canada 45.2
Positive Effects of Advertising
Source: Advertising Age <www.adageglobal.com/cgi-bin/
pages.pl?link=428>. To make rational (efficient) decisions, con-
sumers need information about product
 chapter eleven • monopolistic competition and oligopoly 297

characteristics and prices. Advertising may be a low-cost means of providing that

information. Suppose you are in the market for a high-quality camera and such a
product is advertised in newspapers or magazines. To make a rational choice, you
may have to spend several days visiting stores to determine the prices and features
of various brands. This search entails both direct costs (gasoline, parking fees) and
indirect costs (the value of your time). Advertising reduces your search time and
minimizes these costs.
By providing information about the various competing goods that are available,
advertising diminishes monopoly power. In fact, advertising is frequently associ-
ated with the introduction of new products designed to compete with existing
brands. Could Toyota and Honda have so strongly challenged North American auto
producers without advertising? Could Federal Express have sliced market share
away from UPS and Canada Post without advertising?
Viewed this way, advertising is an efficiency-enhancing activity. It is a rela-
tively inexpensive means of providing useful information to consumers and
thus lowering their search costs. By enhancing competition, advertising results
in greater economic efficiency. By facilitating the introduction of new products,
advertising speeds up technological progress. And by increasing output, advertis-
ing can reduce long-run average total cost by enabling firms to obtain economies
of scale.

Potential Negative Effects of Advertising

Not all the effects of advertising are positive, of course. Much advertising is
designed simply to persuade consumers—that is, to alter their preferences in favour
of the advertiser’s product. A television commercial that indicates that a popular
personality drinks a particular brand of soft drink—and, therefore, that you should
too—conveys little or no information to consumers about price or quality. In addi-
tion, advertising is sometimes based on misleading and extravagant claims that con-
fuse consumers rather than enlighten them. Indeed, in some cases advertising may
well persuade consumers to pay high prices for much-acclaimed but inferior prod-
ucts, forgoing better but unadvertised products selling at lower prices. For example,
Consumer Reports recently found that heavily advertised premium motor oils and
fancy additives provide no better engine performance and longevity than do
cheaper brands.
Firms often establish substantial brand-name loyalty and thus achieve monop-
oly power via their advertising (see Global Perspective 11.2). As a consequence, they
are able to increase their sales, expand their market share, and enjoy greater prof-
its. Larger profit permits still more advertising and further enlargement of the
firm’s market share and profit. In time, consumers may lose the advantages of com-
petitive markets and face the disadvantages of monopolized markets. Moreover,
new entrants to the industry need to incur large advertising costs in order to
establish their products in the marketplace; thus, advertising costs may be a barrier
to entry. (Key Question 11)
Advertising may also be self-cancelling. The advertising campaign of one fast-
food hamburger chain may be offset by equally costly campaigns waged by rivals,
so each firm’s demand actually remains unchanged. Few, if any, extra burgers will
be purchased, and each firm’s market share will stay the same. But because of the
advertising, the cost and hence the price of hamburgers will be higher.
When advertising either leads to increased monopoly power or is self-cancelling,
economic inefficiency results.
298 Part Two • Microeconomics of Product Markets

11.2

The world’s top Coca-Cola

10 brand names
Microsoft
Here are the world’s top 10 brands, IBM
based on four criteria: the brand’s Intel
market share within its category, the Nokia
brand’s world appeal across age
General Electric
groups and nationalities, the loyalty
Ford
of customers to the brand, and the
Disney
ability of the brand to stretch to prod-
McDonald's
ucts beyond the original product.
AT&T

Source: Interbrand, <www.interbrand.com>. Data are for 2000.

Oligopoly and Efficiency

Is oligopoly, then, an efficient market structure from society’s standpoint? How do
the price and output decisions of the oligopolist measure up to the triple equality
P = MC = minimum ATC that occurs in pure competition?

Productive and Allocative Efficiency

Many economists believe that the outcome of some oligopolistic markets is approx-
imately as shown in Figure 11-7. This view is bolstered by evidence that many
oligopolists sustain sizable economic profits year after year. In that case, the oli-
gopolist’s production occurs where price exceeds marginal cost and average total
cost. Moreover, production is below the output at which average total cost is mini-
mized. In this view, neither productive efficiency (P = minimum ATC) nor allocative
efficiency (P = MC) is likely to occur under oligopoly.
A few observers assert that oligopoly is actually less desirable than pure monop-
oly, because government usually regulates pure monopoly in Canada to guard
against abuses of monopoly power. Informal collusion among oligopolists may
yield price and output results similar to those under pure monopoly yet give the
outward appearance of competition involving independent firms.

Qualifications
We should note, however, three qualifications to this view:
1. Increased foreign competition In the past decade, foreign competition has
increased rivalry in several oligopolistic industries—steel, automobiles, photo-
graphic film, electric shavers, outboard motors, and copy machines, for example.
This competition has helped to break down such cozy arrangements as price
leadership and to stimulate more competitive pricing.
 chapter eleven • monopolistic competition and oligopoly 299

2. Limit pricing Recall that some oligopolists may purposely keep prices below
the short-run profit-maximizing level to bolster entry barriers. In essence, con-
sumers and society may get some of the benefits of competition—prices closer to
marginal cost and minimum average total cost—even without the competition
that free entry would provide.
3. Technological advance Over time, oligopolistic industries may foster more
rapid product development and greater improvement of production techniques
than would be possible if they were purely competitive. Oligopolists have large
economic profits from which they can fund expensive research and development
(R&D), and the existence of barriers to entry may give the oligopolist some assur-
ance that it will reap the rewards of successful R&D. Thus, the short-run eco-
nomic inefficiencies of oligopolists may be partly or wholly offset by the
oligopolists’ contributions to better products, lower prices, and lower costs over
time. We will have more to say about these more dynamic aspects of rivalry in
Chapter 12.

OLIGOPOLY IN THE BEER INDUSTRY

The brewing industry has under-
gone profound changes since
World War II that have increased
the degree of concentration in
the industry. In 1945 more than
60 independent brewing compa-
nies existed in Canada. By 1967
there were 18, and by 1984 only
11. While the three largest brew-
ers sold only 19 percent of the
nation’s beer in 1947, the Big
Three brewers (Labatt, Molson,
and Carling O’Keefe) sold 97 per-
cent of the nation’s domestically
produced beer in 1989, the same
year Molson and Carling O’Keefe
merged. Currently, the Big Two—
Labatt (at 41 percent) and Mol-
son (at 52 percent)—produce
most of the beer in Canada. The
industry is clearly an oligopoly.
Changes on the demand side
of the market have contributed
to the shakeout of small brewers
from the industry. First, con-
sumer tastes have generally
The beer industry was once populated by dozen of
firms and an even larger number of brands. It now is an
oligopoly dominated by a handful of producers.
shifted from the stronger- former could now ship their
flavoured beers of the small products by truck or rail without
brewers to the light products of breakage.
the larger brewers. Second, Developments on the supply
there has been a shift from the side of the market have been
consumption of beer in taverns even more profound. Technolog-
to consumption of it in the ical advances have increased the
home. The significance of this speed of the bottling and can-
change is that taverns were usu- ning lines. Today, large brewers
ally supplied with kegs from can fill and close 2000 cans per
local brewers to avoid the rela- line per minute. Large plants are
tively high cost of shipping kegs. also able to reduce labour costs
But the acceptance of aluminum through automating brewing
cans for home consumption and warehousing. Furthermore,
made it possible for large, dis- plant construction costs per bar-
tant brewers to compete with rel are about one-third less for a
the local brewers, because the 4.0 million hectolitres plant than
for a 1.5-million-barrel plant.
As a consequence of these and
other factors, the minimum effi-
cient scale in brewing is a plant
size of about 4.0 million hec-
tolitres, with multiple plants. Be-
cause the construction costs of a
modern brewery of that size is
$450 million, economies of scale
300 Part Two • Microeconomics of Product Markets

may now constitute a significant
barrier to entry.
Blindfold taste tests confirm
that most mass-produced Cana-
dian beers taste alike, so, brew-
ers greatly emphasize advertis-
ing. Here, Labatt and Molson,
who sell national brands, enjoy
major cost advantages over pro-
ducers that have regional brands
(for example, Creemore Springs,
Upper Canada, and Okanagan
Spring). The reason is because
national television advertising is
less costly per viewer than local
spot TV advertising.
Mergers in the brewing in-
dustry have been a fundamental
cause of the rising concentra-
tion. Dominant firms have ex-
panded by heavily advertising
their main brands such as Labatt
Blue, Molson Canadian, Blue
Light, Canadian Light, and Mol-
son Special Dry, sustaining sig-
nificant product differentiation
despite the declining number of
major brewers.
Two factors dominate the
Canadian beer industry: high
transportation costs and provin-
cial policies and practices. High
transportation costs have trans-
lated into a regional structure of
production compared with the
brewing industry in the United
States. As a consequence, a large
number of breweries exist in
Canada relative to the size of the
domestic market. Especially out-
side the larger breweries in On-
tario and Quebec, unit costs are
markedly higher because of the
inability to achieve economies of
scale.
Even more important than
transportation costs, provincial
policies and practices in the past
had a dominant impact on the
Canadian brewing industry; until
recently, brewers were not al-
lowed to transport beer produced
in one province to be sold in an-
other. This restriction has now
been relaxed, and brewers will
centralize operations in the future
to capture economies of scale.
Imported beers such as Beck,
Corona, Foster’s, and Guinness
constitute over 10 percent of the
Canadian market, with individ-
ual brands seeming to wax and
wane in popularity. Some local
or regional microbreweries such
as Upper Canada (purchased re-
cently by Sleeman), which brew
specialty beers and charge pre-
mium prices, have whittled into
the sales of the major brewers.
Labatt and Molson have taken
notice, responding with spe-
cialty brands of their own (for
example, John Labatt Classic
and Molson Signature Spring
Bock). Overall, however, it ap-
pears that imports such as
Heineken and Budweiser may
pose more of a threat to the ma-
jors than the microbreweries do.
Sources: Based on Kenneth G.
Elzinga, “Beer,” in Walter Adams
and James Brock (eds.), The Struc-
ture of American Industry, 9th ed.
(Englewood Cliffs, NJ: Prentice-Hall,
1995), pp. 119–151; Douglas F. Greer,
“Beer: Causes of Structural Change,”
in Larry Duetsch (ed.), Industry
Studies, 2nd ed. (New York: M. E.
Sharpe, 1998), pp. 28–64; authors’
updates; the Conference Board of
Canada, The Canadian Brewing
Industry: Historical Evolution and
Competitive Structure (Toronto: Inter-
national Studies and Development
Group, 1989).

chapter summary
1. The distinguishing features of monopolistic
competition are (a) enough firms are in the
industry to ensure that each firm has only
limited control over price, mutual interde-
pendence is absent, and collusion is nearly
impossible; (b) products are characterized by
real or perceived differences so that eco-
nomic rivalry entails both price and nonprice
competition; and (c) entry to the industry is
relatively easy. Many aspects of retailing,
and some manufacturing industries in which
economies of scale are few, approximate
monopolistic competition.
2. Monopolistically competitive firms may earn
economic profits or incur losses in the short
run. The easy entry and exit of firms result in
only normal profits in the long run.
3. The long-run equilibrium position of the
monopolistically competitive producer is
less socially desirable than that of the pure
competitor. Under monopolistic competition,
 chapter eleven • monopolistic competition and oligopoly 301

price exceeds marginal cost, suggesting an
underallocation of resources to the product,
and price exceeds minimum average total
cost, indicating that consumers do not get
the product at the lowest price that cost con-
ditions might allow.
4. Nonprice competition provides a means by
which monopolistically competitive firms
can offset the long-run tendency for eco-
nomic profit to fall to zero. Through product
differentiation, product development, and
advertising, a firm may strive to increase the
demand for its product more than enough to
cover the added cost of such nonprice com-
petition. Consumers benefit from the wide
diversity of product choice that monopolistic
competition provides.
5. In practice, the monopolistic competitor
seeks the specific combination of price, prod-
uct, and advertising that will maximize profit.
6. Oligopolistic industries are characterized by
the presence of few firms, each having a sig-
nificant fraction of the market. Firms thus
situated are mutually interdependent: the
behaviour of any one firm directly affects,
and is affected by, the actions of rivals. Prod-
ucts may be either virtually uniform or sig-
nificantly differentiated. Various barriers to
entry, including economies of scale, underlie
and maintain oligopoly.
7. Concentration ratios are a measure of oli-
gopoly (monopoly) power. By giving more
weight to larger firms, the Herfindahl index
is designed to measure market dominance in
an industry.
8. Game theory (a) shows the interdependence
of oligopolists’ pricing policies; (b) reveals
the tendency of oligopolists to collude; and
(c) explains the temptation of oligopolists to
cheat on collusive arrangements.
9. Noncollusive oligopolists may face a kinked-
demand curve. This curve and the accompa-
nying marginal-revenue curve help explain
the price rigidity that often characterizes
oligopolies; they do not, however, explain
how the actual prices of products are first
established.
10. The uncertainties inherent in oligopoly pro-
mote collusion. Collusive oligopolists such
as cartels maximize joint profits—that is,
they behave like pure monopolists. Demand
and cost differences, a large number of
firms, cheating through secret price conces-
sions, recessions, and the anti-combines
laws are all obstacles to collusive oligopoly.
11. Price leadership is an informal means of col-
lusion whereby one firm, usually the largest
or most efficient, initiates price changes and
the other firms in the industry follow the
leader.
12. Market shares in oligopolistic industries are
usually determined based on product de-
velopment and advertising. Oligopolists
emphasize nonprice competition because
(a) advertising and product variations are
harder for rivals to match and (b) oligopo-
lists frequently have ample resources to
finance nonprice competition.
13. Advertising may affect prices, competition,
and efficiency either positively or negatively.
Positive: It can provide consumers with low-
cost information about competing products,
help introduce new competing products
into concentrated industries, and generally
reduce monopoly power and its attendant
inefficiencies. Negative: It can promote
monopoly power via persuasion and the cre-
ation of entry barriers. Moreover, it can be
self-cancelling when engaged in by rivals
by boosting costs and increasing economic
inefficiency while accomplishing little else.
14. Neither productive nor allocative efficiency
is realized in oligopolistic markets, but oli-
gopoly may be superior to pure competition
in promoting research and development and
technological progress.

terms and concepts

monopolistic competition,
p. 274
product differentiation, p. 274
nonprice competition, p. 276
excess capacity, p. 281
oligopoly, p. 282
homogeneous oligopoly, p. 283
differentiated oligopoly, p. 283
mutual interdependence, p. 283
concentration ratio, p. 284
interindustry competition,
p. 285
import competition, p. 285
Herfindahl index, p. 285
game theory model, p. 286
collusion, p. 287
kinked-demand curve, p. 288
price war, p. 291
cartel, p. 292
tacit understandings, p. 293
price leadership, p. 295
302 Part Two • Microeconomics of Product Markets
study questions
1. How does monopolistic competition differ
from pure competition in its basic character-
istics? from pure monopoly? Explain fully
what product differentiation may involve.
Explain how the entry of firms into its in-
dustry affects the demand curve facing a
monopolistic competitor and how that, in
turn, affects its economic profit.
2. KEY QUESTION Compare the elastic-
ity of the monopolistic competitor’s demand
with that of a pure competitor and a pure
monopolist. Assuming identical long-run
costs, compare graphically the prices and out-
puts that would result in the long run under
pure competition and under monopolistic
competition. Contrast the two market struc-
tures in terms of productive and allocative
efficiency. Explain: “Monopolistically compet-
itive industries are characterized by too many
firms, each of which produces too little.”
3. “Monopolistic competition is monopolistic
up to the point at which consumers become
willing to buy close-substitute products and
competitive beyond that point.” Explain.
4. “Competition in quality and service may be
just as effective as price competition in giv-
ing buyers more for their money.” Do you
agree? Why? Explain why monopolistically
competitive firms frequently prefer nonprice
competition to price competition.
5. Critically evaluate and explain:
a. “In monopolistically competitive indus-
tries, economic profits are competed
away in the long run; hence, there is no
valid reason to criticize the performance
and efficiency of such industries.”
b. “In the long run, monopolistic competi-
tion leads to a monopolistic price but not
to monopolistic profits.”
6. Why do oligopolies exist? List five or six oli-
gopolists whose products you own or regu-
larly purchase. What distinguishes oligopoly
from monopolistic competition?
7. KEY QUESTION Answer the follow-
ing questions, which relate to measures of
concentration:
a. What is the meaning of a four-firm con-
centration ratio of 60 percent? 90 percent?
What are the shortcomings of concen-
tration ratios as measures of monopoly
power?
b. Suppose that the five firms in industry A
have annual sales of 30, 30, 20, 10, and 10
percent of total industry sales. For the
five firms in industry B the figures are
60, 25, 5, 5, and 5 percent. Calculate the
Herfindahl index for each industry and
compare their likely competitiveness.
8. KEY QUESTION Explain the general
meaning of the following payoff matrix for
oligopolists C and D. All profit figures are in
thousands.
C's possible prices
High Low
D's possible prices
$57 $59
High
$60 $55
$50 $55
Low
$69 $58
a. Use the payoff matrix to explain the
mutual interdependence that character-
izes oligopolistic industries.
b. Assuming no collusion between C and D,
what is the likely pricing outcome?
c. In view of your answer to 8b, explain why
price collusion is mutually profitable.
Why might a temptation to cheat on the
collusive agreement exist?
9. KEY QUESTION What assumptions
about a rival’s response to price changes
underlie the kinked-demand curve for oli-
gopolists? Why is there a gap in the oligop-
olist’s marginal-revenue curve? How does
the kinked-demand curve explain price rigid-
ity in oligopoly? What are the shortcomings
of the kinked-demand model?
10. Why might price collusion occur in oligopo-
listic industries? Assess the economic desir-
ability of collusive pricing. What are the
main obstacles to collusion? Discuss the
weakening of OPEC in the 1980s in terms of
those obstacles.
11. KEY QUESTION Why is there so
much advertising in monopolistic competi-
tion and oligopoly? How does such advertis-
ing help consumers and promote efficiency?
Why might it be excessive at times?
 chapter eleven • monopolistic competition and oligopoly
12. (Advanced analysis) Construct a game the-
ory matrix involving two firms and their
decisions on high versus low advertising
budgets and the effects of each on profits.
Show a circumstance in which both firms
select high advertising budgets even though
both would be more profitable with low
internet application questions
1. Indigo at <www.indigo.ca> is Canada’s
largest online bookseller, but it still has to
compete with the very popular Amazon at
<www.amazon.com>. Search both sites for
Viktor Frankl’s Man’s Search for Meaning (in
paperback). Find the price and determine
which company sells the book at a lower
price (convert Amazon’s price into Canadian
dollars using the current exchange rate at
Yahoo’s financial site, <finance.yahoo.com/
m3?u>. Identify the nonprice competition
that might lead you to order from one com-
pany rather than the other.
303
advertising budgets. Why won’t they unilat-
erally cut their advertising budget?
13. (The Last Word) What firm(s) dominate the
beer industry? What demand and supply fac-
tors have contributed to the small number of
firms in this industry?
2. Advertising Age at <adageglobal.com/cgi-bin/
pages.pl?link=428> compiles statistics on
the large advertisers and advertisements
categories. Go to Ad Age Data Base to find
information on Canadian advertising. Which
ad category has the largest spending? What
is the biggest circulation magazine? How
much does an entire black and white page
advertisement cost in that magazine?
 T W E LV E

Technology,
R&D, and
Efficiency

ust do it! In 1968 two entrepreneurs

IN THIS CHAPTER
Y OU WILL LEARN:
J in Oregon developed a lightweight

sport shoe and formed a new company

called Nike, incorporating a “swoosh” logo

(designed by a graduate student for $35).

To distinguish among an
invention, an innovation, Today, Nike employs more than 20,000 work-
and technological diffusion.
ers and sells more than U.S.$9 billion worth
•
About the role of entrepreneurs of athletic shoes, hiking boots, and sports
and other innovators.
• apparel annually.
A firm’s optimal amount of R&D.
• “Intel inside.” Intel? In 1967 neither this
About the role of market
structure on technological change. company nor its product existed. Today, it is
•
the world’s largest producer of microproces-
How technological advance
enhances both productive
sors for personal computers, with 67,500
and allocative efficiency.
• employees and more than U.S.$29 billion in
About consumer surplus
and producer surplus. annual sales.
 chapter twelve • technology, r&d, and efficiency 305

Nortel Networks, headquartered in Brampton, Ontario, has become the largest

optical fibre manufacturer in the world. Optical fibres allow much faster transmis-
sion of electronic data, which increases the speed of Internet connections.
In 1996 Palm introduced its Palm Pilot, a palm-sized personal computer that now
also has wireless Internet capabilities. A novel idea? Apparently, so: Microsoft, Hand-
spring, OmniSky, and others have followed with similar products, and cell phone
makers are incorporating Internet functionality into some of their new phones.
techno- Each of these brief descriptions entails some elements of technological advance,
logical broadly defined as new and better goods and services and new and better ways of
advance New producing or distributing them. In this chapter, we want to look at some of the
and better goods
and services and
microeconomics of technological advance. Who motivates and implements techno-
new and better logical advance? What determines a firm’s optimal amount of research and devel-
ways of producing opment (R&D)? What is the extent and implications of the imitation problem that
or distributing them. innovators face? Are certain market structures more conducive to technological
advance than others? How does technological advance relate to efficiency? These
are some of the questions we address in this chapter. We also take another look at
allocative and productive efficiency and investigate another way to measure them.

Technological Advance: Invention,

Innovation, and Diffusion
very long For economists, technological advance occurs over a theoretical time period called
run A period in the very long run, which can be as short as a few months or as long as many years.
which technology Recall that in our four market models (pure competition, monopolistic competition,
can change and
in which firms
oligopoly, and pure monopoly), the short run is a period in which technology, plant,
can develop and and equipment are fixed; in the long run, technology is constant but firms can
offer entirely new change their plant sizes and are free to enter or exit industries. In contrast, the very
products. long run is a period in which technology can change and in which firms can develop
invention and offer entirely new products.
The discovery of a In Chapter 2 we saw that technological advance shifts an economy’s produc-
product or process tion possibilities curve outward, enabling the economy to obtain more goods and
through the use of services. Technological advance is a three-step process of invention, innovation, and
imagination, ingen-
ious thinking, and
diffusion.
experimentation
and the first proof Invention
that it will work.
The basis of technological advance is invention: the discovery of a product or process
patent An
through the use of imagination, ingenious thinking, and experimentation and the first proof
exclusive right to
sell any new and that it will work. Invention is a process, and the result of the process is also called an
useful process, invention. The prototypes (basic working models) of the telephone, the automobile,
machine, or product and the microchip are inventions. Invention usually is based on scientific knowl-
for a set time. edge and is the product of individuals, either working on their own or as members
innovation of corporate R&D staffs. Later on you will see how governments encourage inven-
The first successful tion by providing the inventor with a patent, an exclusive right to sell any new and
commercial intro- useful process, machine, or product for a set time.
duction of a new
product, the first use
of a new method of Innovation
production, or the
creation of a new Innovation draws directly on invention. While invention is the “discovery and first
form of business proof of workability,” innovation is the first successful commercial introduction
organization. of a new product, the first use of a new method, or the creation of a new form of
306 Part Two • Microeconomics of Product Markets

product business organization. Innovation is of two types: product innovation, which refers
innovation to new and improved products or services; and process innovation, which refers to
The development new and improved methods of production or distribution.
and sale of a new or
improved product
Unlike inventions, innovations cannot be patented. Nevertheless, innovation is a
or service. major factor in competition, since it sometimes enables a firm to leapfrog competi-
tors by rendering their products or processes obsolete. For example, personal com-
process puters coupled with software for word processing pushed some major typewriter
innovation manufacturers into obscurity. More recently, innovations in hardware retailing
The development
and use of new or
(large warehouse stores such as Home Depot) have threatened the existence of
improved produc- smaller, more traditional hardware stores.
tion or distribution Innovation need not weaken or destroy existing firms. Aware that new products
methods. and processes may threaten their survival, existing firms have a powerful incentive
to engage continually in R&D of their own. Innovative products and processes often
enable such firms to maintain or increase their profits. The introduction of alu-
minum cans by Reynolds, disposable contact lenses by Johnson & Johnson, and sci-
entific calculators by Hewlett-Packard are good examples. Thus, innovation can
either diminish or strengthen market power.

Diffusion
diffusion Diffusion is the spread of an innovation through imitation or copying. To take
The widespread advantage of new profit opportunities or to slow the erosion of profit, both new and
imitation of an existing firms emulate the successful innovations of others. Years ago McDonald’s
innovation.
successfully introduced the fast-food hamburger; Burger King, Swiss Chalet, and
other firms soon copied that idea. Hertz greatly increased its auto rentals by offer-
ing customers unlimited mileage, and Avis, Budget, and others eventually fol-
lowed. DaimlerChrysler profitably introduced a luxury version of its Jeep Grand
Cherokee; other manufacturers, including Acura, Mercedes, and Lexus, countered
with luxury sport-utility vehicles of their own. In each of these cases, innovation has
led eventually to widespread imitation—that is, to diffusion.

R&D Expenditures
As related to businesses, the term “research and development” is used loosely to
include direct efforts toward invention, innovation, and diffusion. However, gov-
ernment also engages in R&D, particularly R&D having to do national defence. In
1999 total Canadian R&D expenditures (business plus government) were $12 billion.
Relative to GDP, that amount was 1.6 percent, which is a reasonable measure of the
emphasis the Canadian economy puts on technological advance. As shown in
Global Perspective 12.1, this is a relatively low percentage of GDP compared to sev-
eral other nations.

Modern View of Technological Advance

For decades most economists regarded technological advance as being external to
the economy—a random outside force to which the economy adjusted. Periodically
fortuitous advances in scientific and technological knowledge occurred, paving the
way for major new products (automobiles, airplanes) and new production processes
(assembly lines). Firms and industries, each at its own pace, then incorporated the
new technology into their products or processes to enhance or maintain their profit.
Then after making the appropriate adjustments, they settled back into new long-run
equilibrium positions. Although technological advance has been vitally important
 chapter twelve • technology, r&d, and efficiency 307

12.1

0 1 2 3
Total R&D expenditures
as a percentage of GDP, Japan
selected nations 1999
United States
Relative R&D spending varies Germany
among the seven leading
France
industrial nations. From a
United Kingdom
microeconomic perspective,
R&D helps promote economic Canada
efficiency; from a macroeco- Italy
nomic perspective, R&D helps
promote economic growth.
Source: National Science Foundation, <www.nsf.gov>.

to the economy, economists believed it was rooted in the independent advance of

science, which is largely external to the market system.
Most contemporary economists have a different view. They see capitalism itself
as the driving force of technological advance. In their view, invention, innovation,
and diffusion occur in response to incentives within the economy, meaning that
technological advance is internal to capitalism. Specifically, technological advance
arises from intense rivalry among individuals and firms that motivates them to seek
and exploit new profit opportunities or to expand existing opportunities. That
rivalry occurs both among existing firms and between existing firms and new firms.
<www.interlog.com/
~womenip/>
Moreover, many advances in pure scientific knowledge are motivated, at least in
Women inventors part, by the prospect of commercial applicability and eventual profit. In the modern
project view, entrepreneurs and other innovators are at the heart of technological advance.

Role of Entrepreneurs and

Other Innovators
It will be helpful to distinguish between entrepreneurs and other innovators:
● Entrepreneurs Recall that the entrepreneur is an initiator, innovator, and risk
bearer—the catalyst who combines land, labour, and capital resources in new
and unique ways to produce new goods and services. In the past a single indi-
vidual, for example, Hart Massey in farm machinery, Henry Ford in automo-
biles, and Levi Strauss in blue jeans, carried out the entrepreneurial role. Such
advances as air conditioning, the ballpoint pen, cellophane, the jet engine,
insulin, xerography, and the helicopter all have an individualistic heritage. But
in today’s more technologically complex economy, entrepreneurship is just as
likely to be carried out by entrepreneurial teams. Such teams may include only
two or three people working as their own bosses on some new product or idea,
or it may consist of larger groups of entrepreneurs who have pooled their
financial resources.
308 Part Two • Microeconomics of Product Markets

● Other innovators This designation includes other key people involved in the
pursuit of innovation who do not bear personal financial risk. Among them are
key executives, scientists, and other salaried employees engaged in commer-
cial R&D activities. (They are sometimes referred to as intrapreneurs, since they
provide the spirit of entrepreneurship within existing firms.)

Forming Start-Ups
start-ups Entrepreneurs often form small new companies called start-ups that focus on cre-
Small new com- ating and introducing a new product or employing a new production or distribu-
panies that focus tion technique. Two people, working out of their garages, formed such a start-up in
on creating and
introducing a new the mid-1970s. Since neither of their employers—Hewlett-Packard and Atari, the
product or employ- developer of Pong (the first video game)—was interested in their prototype per-
ing a new produc- sonal computer, they founded their own company: Apple Computers. Other exam-
tion or distribution ples of successful start-ups are Amgen, a biotechnology firm specializing in new
technique. medical treatments; Second Cup, a seller of gourmet coffee; and Corel, which devel-
ops innovative graphics software.

Innovating within Existing Firms

Innovators are also at work within existing corporations, large and small. Such inno-
vators are salaried workers, though many firms have pay systems that provide them
with substantial bonuses or shares of the profit. Examples of firms known for their
skillful internal innovators are the 3M Corporation, the U.S. developer of Scotch
tape, Post-it Notes, and Thinsulate insulation; and Canon, the Japanese developer
of the laser engine for personal copiers and printers. R&D work in major corpora-
tions has produced significant technological improvements in such products as tel-
evision sets, telephones, home appliances, automobiles, automobile tires, and
sporting equipment.
Some large firms, aware that excessive bureaucracy can stifle creative thinking and
technological advance, have split part of their R&D and manufacturing divisions to
form new, more flexible, innovative firms. One significant example of such a spinoff
firm is Nortel, a telephone equipment and R&D firm created by Bell Canada.

Anticipating the Future

Some 50 years ago a writer for Popular Mechanics magazine boldly predicted, “Com-
puters in the future may weigh no more than 1.5 tons.” Today’s notebook comput-
ers weigh less than two kilograms. It is difficult to anticipate the future, but that is
what innovators try to do. Those with strong anticipatory ability and determination
have a knack for introducing new and improved products or services at just the
right time. The rewards are both monetary and nonmonetary. Product innovation
and development are creative endeavours, with such intangible rewards as personal
satisfaction. Also, many people simply enjoy participating in the competitive con-
test. Of course, the winners can reap huge monetary rewards in the form of eco-
nomic profits, stock appreciation, or large bonuses. Extreme examples are Bill Gates
and Paul Allen, who founded Microsoft in 1975 and had a net worth in 2000 of U.S.$85
billion and U.S.$40 billion, respectively, mainly in the form of Microsoft stock.
Past successes often give entrepreneurs and innovative firms access to resources
for further innovations that anticipate consumer wants. Although they may not suc-
ceed a second time, the market tends to entrust the production of goods and serv-
 chapter twelve • technology, r&d, and efficiency 309

ices to businesses that have consistently succeeded in filling consumer wants. And
the market does not care whether these winning entrepreneurs and innovative firms
are Canadian, American, Brazilian, Japanese, German, or Swiss. Entrepreneurship
and innovation are global in scope.

Exploiting University and Government Scientific Research

Only a small percentage of R&D spending goes to basic scientific research. The rea-
son that percentage is so small is that scientific principles, as such, cannot be
patented, nor do they usually have immediate commercial uses. Yet new scientific
knowledge is highly important to technological advance. For that reason, entrepre-
neurs study the scientific output of university and government laboratories to iden-
tify discoveries with commercial applicability.
Government and university labs have been the scene of many technological
breakthroughs. Entire high-tech industries such as computers and biotechnology,
for example, have their roots in major research universities and government labo-
ratories, and nations with strong scientific communities tend to have the most tech-
nologically progressive firms and industries.
Also, firms increasingly help to fund university research that relates to their prod-
ucts. Business funding of R&D at universities has grown rapidly. Today, the sepa-
ration between university scientists and innovators is narrowing; scientists and
universities increasingly realize that their work may have commercial value and are
teaming up with innovators to share in the potential profit. A few firms, of course,
find it profitable to conduct basic scientific research on their own. New scientific
knowledge can give them a head start in creating an invention or a new product.
This is particularly true in the pharmaceutical industry, where it is not uncommon
for firms to parlay new scientific knowledge generated in their corporate labs into
new, patentable drugs.

● Broadly defined, technological advance means
new or improved products and services and
new or improved production and distribution
processes.
● Invention is the discovery of a new product or
method; innovation is the successful commer-
cial application of some invention; and diffusion
is the widespread imitation of the innovation.
● Many economists view technological advance
as mainly a response to profit opportunities
arising within a capitalist economy.
● Technological advance is fostered by entrepre-
neurs and other innovators and is supported
by the scientific research of universities and
government-sponsored laboratories.

A Firm’s Optimal Amount of R&D

How does a firm decide on its optimal amount of research and development? That
amount depends on the firm’s perception of the marginal benefit and marginal cost
of R&D activity. The decision rule here flows from basic economics: To earn the
greatest profit, expand a particular activity until its marginal benefit (MB) equals
its marginal cost (MC). A firm that sees the marginal benefit of a particular R&D
310 Part Two • Microeconomics of Product Markets

activity, say, innovation, as exceeding the marginal cost should expand that activity.
In contrast, an activity whose marginal benefit promises to be less than its marginal
cost should be cut back. But the R&D spending decision is complex, since it involves
a present sacrifice for a future expected gain. While the cost of R&D is immediate,
the expected benefits occur at some future time and are highly uncertain, so esti-
mating those benefits is often more art then science. Nevertheless, the MB = MC way
of thinking remains relevant for analyzing R&D decisions.

Interest-Rate Cost of Funds

Firms have several ways of obtaining the funds they need to finance R&D activities:
● Bank loans Some firms are able to obtain a loan from a bank or other finan-
cial institution. The cost of using the funds is the interest paid to the lender.
The marginal cost is the cost per extra dollar borrowed, which is simply the
market interest rate for borrowed funds.
● Bonds Established, profitable firms may be able to borrow funds for R&D by
issuing bonds and selling them in the bond market. In this case, the cost is the
interest paid to the lenders—the bondholders. Again, the marginal cost of
using the funds is the interest rate.
● Retained earnings A large, well-established firm may be able to draw on its
own corporate savings to finance R&D. Typically, such a firm retains part of its
profit rather than paying it all out as dividends to corporate owners. Some of
the undistributed corporate profit, called retained earnings, can be used to
finance R&D activity. The marginal cost is the rate at which those funds could
have earned interest as deposits in a financial institution.
● Venture capital A smaller start-up firm might be able to attract venture cap-
ital to finance its R&D projects. Venture capital is financial capital, or simply
venture money, not real capital. Venture capital consists of that part of household sav-
capital Finan- ing used to finance high-risk business ventures in exchange for shares of the
cial capital lent in profit if the ventures succeed. The marginal cost of venture capital is the share
return for a share
in the business.
of expected profit that the firm will have to pay to those who provided the
money. This share can be stated as a percentage of the venture capital, so it is
essentially an interest rate.
● Personal savings Finally, individual entrepreneurs might draw on their own
savings to finance the R&D for a new venture. The marginal cost of the financ-
ing is the forgone interest rate.
Thus, whatever the source of the R&D funds, we can state the marginal cost of these
funds as an interest rate, i. For simplicity, let’s assume that this interest rate is the
same no matter how much financing is required. Further, we assume that a certain
firm called MedTech must pay an interest rate of 8 percent, the least expensive fund-
ing available to it. Then a graph of the marginal cost of each funding amount for this
interest- firm is a horizontal line at the 8 percent interest rate, as shown in Figure 12-1. Such
rate cost- a graph is called an interest-rate cost-of-funds curve. This one tells us that MedTech
of-funds can borrow $10, $10,000, $10,000,000 or more at the 8 percent interest rate. The table
curve A graph accompanying the graph contains the data used to construct the graph and tells us
showing the inter-
est rate a firm must
much the same thing.
pay to obtain funds With these data in hand, MedTech wants to determine how much R&D to finance
to finance R&D. in the coming year.
 chapter twelve • technology, r&d, and efficiency 311

FIGURE 12-1 THE INTEREST-RATE COST-OF-FUNDS SCHEDULE

AND CURVE
20
R&D,
millions Interest-rate cost of funds, %
16
$10 8
Interest rate, i (percent)

20 8
30 8
12
40 8
Interest-rate cost-of-funds 50 8
curve 60 8
8 i 70 8
80 8

0 20 40 60 80 100
Research and development expenditures
(millions of dollars)
As it relates to R&D, a firm’s interest-rate cost-of-funds schedule (the table) and curve (the graph) show the interest rate the
firm must pay to obtain any particular amount of funds to finance R&D. Curve i indicates that the firm can finance as little or
as much R&D as it wants at a constant 8 percent rate of interest.

Expected Rate of Return

A firm’s marginal benefit from R&D is its expected profit (or return) from the last
(marginal) dollar spent on R&D. That is, the R&D is expected to result in a new
product or production method that will increase revenue, reduce production costs,
or both (in ways we will soon explain). This return is expected but not certain—
there is risk in R&D decisions. Let’s suppose that after considering such risks,
MedTech anticipates that an R&D expenditure of $1 million will result in a new
<www.bothell. product that will yield a one-time added profit of $1.2 million a year later. The
washington.edu/
expected rate of return, r, on the $1 million R&D expenditure (after the $1 million
faculty/danby/bls324/
surplus.html> has been repaid) is 20 percent (= $200,000/ $1,000,000). This is the marginal benefit
Demand, supply, and of the first $1 million of R&D. (Stretching the return over several years complicates
surpluses the computation of r, but it does not alter the basic analysis.)
MedTech can use this same method to estimate the expected rates of return for
R&D expenditures of $2 million, $3 million, $4 million, and so on. Suppose those
marginal rates of return are the ones indicated in the table in Figure 12-2, where they
expected- are also graphed as the expected-rate-of-return curve. This curve shows the
rate-of- expected rate of return, which is the marginal benefit, of each dollar of expenditure
return on R&D. The curve slopes downward because of diminishing returns to R&D
curve The
increase in profit a expenditures. A firm will direct its initial R&D expenditures to the highest expected-
firm anticipates it rate-of-return activities and then use additional funding for activities with succes-
will obtain by sively lower expected rates of return. That is, as the firm increases R&D spending,
investing in R&D. it uses it to finance R&D activities with progressively lower expected rates of return.
312 Part Two • Microeconomics of Product Markets

FIGURE 12-2 THE EXPECTED-RATE-OF-RETURN SCHEDULE

AND CURVE
20
R&D,
Expected rate of return, %
Expected rate of return, r (percent)

millions
16
$10 18
Expected-rate-of- 20 16
return curve 30 14
12
40 12
50 10
60 8
8 6
70
80 4

4 r

0 20 40 60 80 100
Research and development expenditures
(millions of dollars)
As they relate to R&D, a firm’s expected-rate-of-return schedule (the table) and curve (the graph) show the firm’s expected
gain in profit, as a percentage of R&D spending, for each level of R&D spending. Curve r slopes downward because the firm
assesses its potential R&D projects in descending order of expected rates of return.

Optimal R&D Expenditures

Figure 12-3 combines the interest-rate-cost-of-funds curve (Figure 12-1) and the
optimal expected-rate-of-return curve (Figure 12-2). The curves intersect at MedTech’s opti-
amount of mal amount of R&D, which is $60 million. This amount can also be determined from
r&d The amount the table as the amount of funding for which the expected rate of return and the
of funding for which
the expected rate of interest cost of borrowing are equal (here, 8 percent). Both the curve and the table tell
return and the inter- us that at $60 million of R&D expenditures, the marginal benefit and marginal cost
est cost of borrow- of the last dollar spent on R&D are equal. This firm should undertake all R&D
ing are equal. expenditures up to $60 million, since those outlays yield a higher marginal benefit or
expected rate of return, r, than the 8 percent marginal cost or interest-rate cost of bor-
rowing, i. But MedTech should not undertake R&D expenditures beyond $60 million;
for these outlays, r (marginal benefit) is less than i (marginal cost). Only at $60 mil-
lion do we have r = i, telling us that MedTech will spend $60 million on R&D.
Our analysis reinforces two important points:
1. Optimal versus affordable R&D From earlier discussions we know there can
be too much, as well as too little, of a good thing. So it is with R&D and techno-
logical advance. Figure 12-3 shows that R&D expenditures make sense to a firm
only as long as the expected return from the outlay equals or exceeds the cost of
obtaining the funds needed to finance it. Many R&D expenditures may be
affordable but not worthwhile, because their marginal benefit is likely to be less
than their marginal cost.
 chapter twelve • technology, r&d, and efficiency 313

FIGURE 12-3 A FIRM’S OPTIMAL LEVEL OF R&D EXPENDITURES

20
Expected R&D, Interest-rate cost
rate of return, % millions of funds, %
Expected rate of return, r, and

16
interest rate, i (percent)

18 $10 8
16 20 8
12 14 30 8
12 40 8
10 50 8
r=i
8 i 8 60 8
6 70 8
4 80 8
4 r

0 20 40 60 80 100
Research and development expenditures
(millions of dollars)
The firm’s optimal level of R&D expenditures ($60 million) occurs where its expected rate of return equals the interest-rate
cost of funds, as shown in both the table and the graph. At $60 million of R&D spending, the firm has taken advantage of all
R&D opportunities for which the expected rate of return, r, exceeds or equals the 8 percent interest cost of borrowing, i.

2. Expected, not guaranteed, returns The outcomes from R&D are expected, not
guaranteed. With 20/20 hindsight, a firm can always look back and decide
whether a particular expenditure for R&D was worthwhile, but that assessment
is irrelevant to the original decision. At the time of the decision, the expenditure
was thought to be worthwhile, based on existing information and expectations.
Some R&D decisions may be more like an informed gamble than the typical busi-
ness decision. Invention and innovation, in particular, carry with them a great
deal of risk. For every successful outcome, there are scores of costly disappoint-
ments. (Key Questions 4 and 5)

Increased Profit via Innovation

In discussing how a firm determines its optimal amount of R&D spending, we side-
stepped the question of how technological change can increase a firm’s profit.
Although the answer may seem obvious—by increasing revenue or reducing pro-
duction costs—insights can be gained by exploring these two potential outcomes in
some detail.

Increased Revenue via Product Innovation

Firms here and abroad have profitably introduced hundreds of new products in the
past two or three decades. Examples include inline skates, microwave popcorn,
cordless drills, digital cameras, camcorders, and projection TVs. Other new products
314 Part Two • Microeconomics of Product Markets

are snowboards, cellular phones, telephone pagers, and automobile air bags. All
these items reflect technological advance in the form of product innovation.
How do such new products gain consumer acceptance? As you know from Chap-
ter 7, to maximize their satisfaction, consumers purchase products that have the
highest marginal utility per dollar. They determine which products to buy in view
of their limited money income by comparing the ratios of MU/price for the various
goods. They first select the unit of the good with the highest MU/price ratio, then
the one with the next highest, and so on, until their income is used up.
The first five columns of Table 12-1 repeat some of the information in Table 7-1.
Before the introduction of new product C, the consumer maximized total utility
from $10 of income by buying two units of A at $1 per unit and four units of B at $2
per unit. The total $10 budget was thus expended, with $2 spent on A and $8 on B.
As shown in columns 2(b) and 3(b), the marginal utility per dollar spent on the last
unit of each product was 8 (= 8/$1 = 16/$2). The total utility, derived from columns
2(a) and 3(a), was 96 utils (= 10 + 8 from the first 2 units of A plus 24 + 20 + 18 + 16
from the first 4 units of B). (If you are uncertain about this outcome, please review
the discussion of Table 7-1.)
Now suppose an innovative firm offers new product C (columns 4(a) and 4(b) in
Table 12-1), priced at $4 per unit. Note that the first unit of C has a higher marginal
utility per dollar (13) than any unit of A and B and that the second unit of C and the
first unit of B have equal MU/price ratios of 12. To maximize satisfaction, the con-
sumer now buys two units of C at $4 per unit, one unit of B at $2 per unit, and zero
units of A. Our consumer has spent the entire $10 of income ($8 on C and $2 on B),
and the MU/price ratios of the last units of B and C are equal at 12. But as deter-
mined via columns 3(a) and 4(a), the consumer’s total utility is now 124 utils (= 24
from the first unit of B plus 52 + 48 from the first 2 units of C). Total utility has
increased by 28 utils (= 124 utils – 96 utils) and that is why product C was pur-
chased. Consumers will buy a new product only if it increases the total utility they obtain
from their limited income.

TABLE 12-1 UTILITY MAXIMIZATION WITH THE INTRODUCTION

OF A NEW PRODUCT (INCOME = $10)*
(1) (2) (3) (4)
Unit of Product A: price = $1 Product B: price = $2 New product C: price = $4
product
(a) (b) (a) (b) (a) (b)
Marginal Marginal Marginal Marginal Marginal Marginal
utility, utils utility utility, utils utility utility, utils utility
per dollar per dollar per dollar
(MU/price) (MU/price) (MU/price)

First 10 10 24 12 52 13
Second 8 8 20 10 48 12
Third 7 7 18 9 44 11
Fourth 6 6 16 8 36 9
Fifth 5 5 12 6 32 8
*It is assumed in this table that the amount of marginal utility received from additional units of each of the three products is inde-
pendent of the quantity purchased of the other products. For example, the marginal utility schedule for product C is independent
of the amount of A and B purchased by the consumer.
 chapter twelve • technology, r&d, and efficiency 315

From the innovating firm’s perspective, these dollar votes represent new-product
demand that yields increased revenue. When per-unit revenue exceeds per-unit
cost, the product innovation creates per-unit profit. Total profit rises by the per-unit
profit multiplied by the number of units sold. As a percentage of the original R&D
expenditure, the rise in total profit is the return on that R&D expenditure. It was the
basis for the expected-rate-of-return curve r in Figure 12-2.
Several other related points are worth noting:
● Importance of price Consumer acceptance of a new product depends on both
its marginal utility and its price. (Confirm that the consumer represented in
Table 12-1 would buy zero units of new product C if its price were $8 rather
than $4.) To be successful, a new product must not only deliver utility to con-
sumers but do so at an acceptable price.
● Unsuccessful new products For every successful new product, hundreds do
not succeed; the expected return that motivates product innovation is not
always realized. Examples of colossal product flops are Ford’s Edsel automo-
bile, 3-D movies, quadraphonic stereo, New Coke by Coca-Cola, Kodak disc
cameras, and McDonald’s McLean burger. Less dramatic failures include the
hundreds of dot.com firms that have recently failed. In each case, millions of
dollars of R&D and promotion expense ultimately resulted in loss, not profit.
● Product improvements Most product innovation consists of incremental
improvements to existing products rather than radical inventions, such as
more fuel-efficient automobile engines, new varieties of pizza, lighter-weight
shafts for golf clubs, more flavourful bubble-gum, rock shocks for mountain
bikes, and clothing made of wrinkle-free fabrics. (Key Question 6)

Reduced Cost via Process Innovation

The introduction of better methods of producing products—process innovation—is
also a path toward enhanced profit and a positive return on R&D expenditures. Sup-
pose a firm introduces a new and better production process, say, assembling its
product by teams rather than by a standard assembly line. Alternatively, suppose
this firm replaces old equipment with more productive equipment embodying tech-
nological advance. In either case, the innovation yields an upward shift in the firm’s
total-product curve from TP1 to TP2 in Figure 12-4(a). Now more units of output can
be produced at each level of resource usage. Note from the figure, for example, that
this firm can now produce 2500 units of output, rather than 2000 units, when using
1000 units of labour. So its average product has increased from 2 (= 2000 units of
output ÷ 1000 units of labour) to 2.5 (= 2500 units of output ÷ 1000 units of labour).
The result is a downward shift in the firm’s average-total-cost curve, from ATC1
to ATC2 in Figure 12-4(b). To understand why, let’s assume this firm pays $1000 for
the use of its capital and $9 for each unit of labour. Since it uses 1000 units of labour,
its labour cost is $9000 (= $9 × 1000); its capital cost is $1000; and thus its total cost
is $10,000. When its output increases from 2000 to 2500 units as a result of the
process innovation, its total cost remains $10,000, and its average total cost declines
from $5 (= $10,000/2000) to $4 (= $10,000/2500). Alternatively, the firm could pro-
duce the original 2000 units of output with fewer units of labour at an even lower
average total cost.
This reduction in average total cost enhances the firm’s profit. As a percentage
of the R&D expenditure that fostered it, this extra profit is the expected return r,
the basis for the rate-of-return-curve in Figure 12-2. In this case, the expected
316 Part Two • Microeconomics of Product Markets

FIGURE 12-4 PROCESS INNOVATION, TOTAL PRODUCT, AND

AVERAGE TOTAL COST

Average total cost

TP2
Total product

2500 ATC1
TP1 ATC2
2000
$5
4

0 1000 0 2000 2500

Units of labour Units of output
(a) Upward shift of the total-product curve (b) Downward shift of the average-total-
cost curve
Panel (a): Process innovation shifts a firm’s total-product curve upward from TP1 to TP2, meaning that with a given amount of
capital, the firm can produce more output at each level of labour input. As shown, with 1000 units of labour it can produce
2500 rather than 2000 units of output. Panel (b): The upward shift in the total-product curve results in a downward shift in the
firm’s average-total-cost curve, from ATC1 to ATC2. This shift means the firm can produce any particular unit of output at a
lower average total cost than it could previously. For example, the original 2000 units can be produced at less than $4 per unit,
versus $5 per unit originally. Or 2500 units can now be produced at $4 per unit.

rate of return arose from the prospect of lower production costs through process
innovation.
Consider this example: Computer-based inventory control systems, such as those
pioneered by Wal-Mart, enabled innovators to reduce the number of people keep-
ing track of inventories and placing reorders of sold goods. They also enabled firms
to keep goods arriving just in time, reducing the cost of storing inventories. The con-
sequence? Significant increases in sales per worker, declines in average total cost,
and increased profit. (Key Question 8)

Imitation and R&D Incentives

Our analysis of product and process innovation explains how technological advance
imitation enhances a firm’s profit, but it also hints at a potential imitation problem: a firm’s
problem A rivals may be able to imitate the new product or process, greatly reducing the orig-
firm’s rivals may be inator’s profit from its R&D effort. As just one example, in the 1980s North Ameri-
able to imitate the
new product or
can auto firms took apart Japanese Honda Accords, piece by piece, to discover the
process, greatly secrets of their high quality. This reverse engineering—which ironically was per-
reducing the origi- fected earlier by the Japanese—helped the U.S. firms to incorporate innovative fea-
nator’s profit from tures into their own cars. This type of imitation is perfectly legitimate and fully
its R&D effort. anticipated; it is often the main path to widespread diffusion of an innovation.
In fact, a dominant firm that is making large profits from its existing products
may let smaller firms in the industry incur the high costs of product innovation
while it closely monitors their successes and failures. The dominant firm then
 chapter twelve • technology, r&d, and efficiency 317

moves quickly to imitate any successful new product; its goal is to become the
fast-second second firm to embrace the innovation. In using this so-called fast-second strategy,
strategy The the dominant firm counts on its own product-improvement abilities, marketing
strategy of becom- prowess, or economies of scale to prevail.
ing the second firm
to embrace an inno-
vation, allowing the Benefits of Being First
originator to incur
the initial high costs Imitation and the fast-second strategy raise an important question: What incentive
of innovation. is there for any firm to bear the expenses and risks of innovation if competitors can
imitate their new or improved product? Why not let others bear the costs and risks
of product development and then just imitate the successful innovations? Although
we have seen that this may be a plausible strategy in some situations, there are sev-
eral protections for, and potential advantages to, taking the lead.

PATENTS
Some technological breakthroughs, specifically inventions, can be patented. Once
patented, they cannot be legally imitated for almost two decades. The purpose of
patents is, in fact, to reduce imitation and its negative effect on the incentive for
engaging in R&D. For example, Polaroid’s patent of its instant camera enabled it to
earn high economic profits for many years. When Kodak cloned the camera,
Polaroid won a patent-infringement lawsuit against its rival. Kodak not only had to
stop producing its version of the camera but had to buy back the Kodak instant cam-
eras it had sold and pay millions of dollars in damages to Polaroid.

COPYRIGHTS AND TRADEMARKS

Copyrights protect publishers of books, computer software, movies, videos, and
musical compositions from having their works copied. Trademarks give the original
innovators of products the exclusive right to use a particular product name (M&Ms,
Barbie Doll, Wheaties). By reducing the problem of direct copying, these legal pro-
tections increase the incentive for product innovation. They have been strengthened
worldwide through recent international trade agreements.

BRAND-NAME RECOGNITION
Along with trademark protection, brand-name recognition may give the original
innovator a major marketing advantage for years or even decades. Consumers
often identify a new product with the firm that first introduced and popularized it
in the mass market. Examples: Levi’s blue jeans, Kleenex’s soft tissues, Johnson and
Johnson’s Band-Aids, Sony’s Walkman, and Kellogg’s Corn Flakes.

TRADE SECRETS AND LEARNING BY DOING

Some innovations involve trade secrets, without which competitors cannot imitate
the product or process. For example, Coca-Cola has successfully kept its formula for
Coke a secret from potential rivals. Many other firms have perfected special pro-
duction techniques known only to them. In a related advantage, a firm’s head-start
with a new product often allows it to achieve substantial cost reductions through
learning by doing. The innovator’s lower cost may enable it to continue to profit
even after imitators have entered the market.

TIME LAGS
Time lags between innovation and diffusion often enable innovating firms to real-
ize a substantial economic profit. It takes time for an imitator to gain knowledge of
318 Part Two • Microeconomics of Product Markets

FIGURE 12-5 THE GROWTH OF BUSINESS R&D EXPENDITURES

IN CANADA, 1981–1998

Industrial R&D expenditures in Canada

Inflation-adjusted
14
R&D expenditures by
firms are substantial
and growing, sug-

(billions of 1990 dollars)

12
gesting that R&D
continues to be
profitable for firms,
10
even in the face of
possible imitation.
8

4
1981 1984 1987 1990 1993 1996 1998
Source: National Science Foundation. <www.nsf.gov>.

the properties of a new innovation. And once it has that knowledge, the imitator
must design a substitute product, gear up a factory for its production, and conduct
a marketing campaign. Various entry barriers such as large financial requirements,
economies of scale, and price-cutting may extend the time lag between innovation
and imitation. In practice, it may take years or even decades before rival firms can
successfully imitate a profitable new product and cut into the market share of the
innovator. In the meantime, the innovator continues to profit.

PROFITABLE BUYOUTS
A final advantage of being first arises from the possibility of a buyout (outright pur-
chase) of the innovating firm by a larger firm. Here, the innovative entrepreneurs
take their rewards immediately, as cash or as shares in the purchasing firm, rather
than waiting for perhaps uncertain long-run profits from their own production and
marketing efforts.
In short, despite the imitation problem, there are significant protections and
advantages that enable most innovating firms to profit from their R&D efforts, as
implied by the continuing high levels of R&D spending by firms year after year. As
shown in Figure 12-5, business R&D spending in Canada not only remains sub-
stantial but has grown over the past quarter-century. The high levels of spending
simply would not continue if imitation consistently and severely depressed rates of
return on R&D expenditures.

● A firm’s optimal R&D expenditure is the amount the interest-rate cost of borrowing (marginal
at which the expected rate of return (marginal cost) required to finance it.
benefit) from the R&D expenditure just equals
 chapter twelve • technology, r&d, and efficiency 319

● Product innovation can entice consumers to sub-
stitute a new product for existing products to
increase their total utility, thereby increasing
the innovating firm’s revenue and profit.
● Process innovation can lower a firm’s produc-
tion costs and increase its profit by increasing
total product and decreasing average total cost.
● A firm faces reduced profitability from R&D if
competitors can successfully imitate its new
product or process. Nevertheless, being first has
significant potential protections and benefits,
including patents, copyrights, and trademarks;
brand-name recognition, trade secrets, and cost
reductions from learning by doing; and major
time lags between innovation and imitation.

Role of Market Structure

In view of our discussion of market structures in the past three chapters, it is logi-
cal to ask whether some particular market structure or firm size is best suited to
technological progress. Is a highly competitive industry comprising thousands of
relatively small firms preferable to an industry comprising only two or three large
firms? Or is some intermediate structure best?

Market Structure and Technological Advance

As a first step toward answering these questions, we survey the strengths and short-
comings of our four market models as related to technological advance.

PURE COMPETITION
Does a pure competitor have a strong incentive and strong ability to undertake
R&D? On the positive side, strong competition provides a reason for these firms
to innovate; competitive firms tend to be less complacent than monopolists. If a
pure competitor does not seize the initiative, one or more rivals may introduce
a new product or cost-reducing production technique that could drive the firm
from the market. As a matter of short-term profit and long-term survival, the pure
competitor is under continual pressure to improve products and lower costs
through innovation. Also, where there are many competing firms, there is less
chance that an idea for improving a product or process will be overlooked by a
single firm.
On the negative side, the expected rate of return on R&D may be low or even neg-
ative for a pure competitor. Because of easy entry, its profit rewards from innova-
tion may quickly be competed away by existing or entering firms that also produce
the new product or adopt the new technology. Also, the small size of competitive
firms and the fact that they earn only a normal profit in the long run leads to seri-
ous questions about whether they can finance substantial R&D programs. Observers
have noted that the high rate of technological advance in the purely competitive
agricultural industry, for example, has come not from the R&D of individual farm-
ers but from government-sponsored research and from the development of fertiliz-
ers, hybrid seed, and farm implements by oligopolistic-firms.

MONOPOLISTIC COMPETITION
Like pure competitors, monopolistic competitors cannot afford to be complacent.
But unlike pure competitors, which sell standardized products, monopolistic com-
petitors have a strong profit incentive to engage in product development. This
incentive to differentiate their products from those of competitors stems from the
fact that sufficiently novel products may create monopoly power and thus economic
320 Part Two • Microeconomics of Product Markets

profit. Examples abound of innovative firms (McDonald’s, Blockbuster Video) that

started out as monopolistic competitors in localized markets but soon gained con-
siderable national market power, with the attendant economic profit.
For the typical firm, however, the shortcomings of monopolistic competition in
relation to technological advance are the same as those of pure competition. Most
monopolistic competitors remain small, which limits their ability to secure inex-
pensive financing for R&D. In addition, monopolistic competitors find it difficult to
extract large profits from technological advances. Any economic profits from inno-
vation are usually temporary, because entry to monopolistically competitive indus-
tries is relatively easy. In the long run, new entrants with similar goods reduce the
demand for the innovator’s product, leaving the innovator with only a normal
profit. Monopolistic competitors, therefore, usually have relatively low expected
rates of return on R&D expenditures.

OLIGOPOLY
Many of the characteristics of oligopoly are conducive to technological advance.
First, the large size of oligopolists enables them to finance the often large R&D
costs associated with major product or process innovation. In particular, the typi-
cal oligopolist realizes ongoing economic profits, a part of which is retained. This
undistributed profit serves as a major source of readily available, relatively low-
cost funding for R&D. Moreover, the existence of barriers to entry gives the oligop-
olist some assurance that it can maintain any economic profit it gains from
innovation. Then, too, the large sales volume of the oligopolist enables it to spread
the cost of specialized R&D equipment and teams of specialized researchers over a
great many units of output. Finally, the broad scope of R&D activity within oligop-
olistic firms helps them offset the inevitable R&D misses with more than com-
pensating R&D hits. Thus, oligopolists clearly have the means and incentive to
innovate.
But R&D in oligopoly also has a negative side. In many instances, the oligopo-
list’s incentive to innovate may be far less than we have implied above, because oli-
gopoly tends to breed complacency. An oligopolist may reason that it makes little
sense to introduce costly new technology and produce new products when it cur-
rently is earning a sizable economic profit without them. The oligopolist wants to
maximize its profit by exploiting fully all its capital assets. Why rush to develop a
new product (say, batteries for electric automobiles) when that product’s success
will render obsolete much of the firm’s current equipment designed to produce its
existing product (say, gasoline engines)? It is not difficult to cite oligopolistic indus-
tries in which the largest firms’ interest in R&D has been quite modest—the steel,
cigarette, and aluminum industries, for example.

PURE MONOPOLY
In general, the pure monopolist has little incentive to engage in R&D; it maintains
its high profit through entry barriers that, in theory, are complete. The only incen-
tive for the pure monopolist to engage in R&D is defensive: to reduce the risk of
being blindsided by some new product or production process that destroys its
monopoly. If such a product is out there to be discovered, the monopolist may have
an incentive to find it. By so doing, it can either exploit the new product or process
for continued monopoly profit or suppress the product until it has extracted the
maximum profit from its current capital assets. But, in general, economists agree
that pure monopoly is the market structure least conducive to innovation.
 chapter twelve • technology, r&d, and efficiency 321

Inverted-U Theory
Analysis like this has led some experts on technological progress to postulate a so-
inverted-u called inverted-U theory of the relationship between market structure and techno-
theory of logical advance. This theory is illustrated in Figure 12-6, which relates R&D
r&d A theory spending as a percentage of a firm’s sales (vertical axis) to the industry’s four-firm
saying that, other
things being equal, concentration ratio (horizontal axis). The inverted-U shape of the curve suggests
R&D expenditures that R&D effort is at best weak in both very low concentration industries (pure com-
as a percentage petition) and very high concentration industries (pure monopoly). Starting from the
of sales rise with lowest concentrations, R&D spending as a percentage of sales rises with concentra-
industry concentra- tion until a concentration ratio of 50 percent or so is reached, meaning that the four
tion, reach a peak
at a four-firm con- largest firms account for about one-half the total industry output. Beyond that, rel-
centration ratio of ative R&D spending decreases as concentration rises.
about 50 percent, The logic of the inverted-U theory follows from our discussion. Firms in indus-
and then fall as con- tries with very low concentration ratios are mainly competitive firms. They are
centration further small, which makes it difficult for them to finance R&D. Entry to these industries is
increases.
easy, making it difficult to sustain economic profit from innovations that are not
supported by patents. As a result, firms in these industries spend little on R&D rel-
ative to their sales. At the other end (far right) of the curve, where concentration is
exceptionally high, monopoly profit is already high and innovation will not add
much more profit. Furthermore, innovation typically requires costly retooling of
very large factories, which will cut into whatever additional profit is realized. As a
result, the expected rate of return from R&D is quite low, as are expenditures for
R&D relative to sales. Finally, the lack of rivals makes the monopolist quite com-
placent about R&D.
The optimal industry structure for R&D is one in which expected returns on R&D
spending are high and funds to finance it are readily available and inexpensive.
From our discussion, those factors seem to occur in industries where a few firms are
absolutely and relatively large but where the concentration ratio is not so high as to
prohibit vigorous competition by smaller rivals. Rivalry among the larger oligopo-
listic firms and competition between the larger and smaller firms then provide a

FIGURE 12-6 THE INVERTED-U THEORY OF R&D EXPENDITURES

The inverted-U theory
suggests that R&D
expenditures as a More competition Less competition
R&D expenditures as a

percentage of sales
percentage of sales

rise with industry

concentration until
the four-firm concen-
tration ratio reaches
about 50 percent.
Further increases in
industry concentra-
tion are associated
with lower R&D
expenditures.

0 25 50 75 100
Concentration ratio (percent)
322 Part Two • Microeconomics of Product Markets

strong incentive for R&D. The inverted-U theory, as represented by Figure 12-6, also
points toward this loose oligopoly as the optimal structure for R&D spending.

Market Structure and Technological Advance: The Evidence

Dozens of industry studies have tried to pin down the relationship between market
structure and technological advance. Because those studies dealt with different
industries and time periods, and used different methodologies, they are not easy to
compare and summarize. Nevertheless, they provide general support for the
inverted-U theory.1 Other things being equal, the optimal market structure for tech-
nological advance seems to be an industry in which there is a mix of large oligopo-
listic firms (a 40 to 60 percent concentration ratio), with several highly innovative
smaller firms.
Our “other things being equal” qualification is quite important here. Whether a
particular industry is highly technical may well be a more important determinant
of R&D than its structure. While some concentrated industries (electronics, aircraft,
and petroleum) devote large quantities of resources to R&D and are very innova-
tive, others (cigarettes, aluminum, gypsum products) are not. The level of R&D
spending within an industry seems to depend as much on its technical character and
technological opportunities as on its market structure. There simply may be more
opportunities to innovate in the computer and pharmaceutical industries, for exam-
ple, than in the brick-making and coal-mining industries.
The conclusion: The inverted-U curve shown in Figure 12-6 is a useful depiction
of the general relationship between R&D spending and market structure, other
things being equal.

Technological Advance and Efficiency

Production Technological advance contributes significantly to economic efficiency. New and
and the
Standard of
better processes and products enable society to produce more output, as well as a
Living higher-valued mix of output.

Productive Efficiency
Technological advance as embodied in process innovation improves productive effi-
ciency by increasing the productivity of inputs, as indicated in Figure 12-4(a), and by
reducing average total costs, as in Figure 12-4(b). In other words, it enables society
to produce the same amount of a particular good or service while using fewer scarce
resources, thereby freeing the unused resources to produce other goods and services.
Or if society desires more of the now less expensive good, process innovation enables
it to have that greater quantity without sacrificing other goods. Viewed either way,
process innovation enhances productive efficiency: it reduces society’s per-unit cost
of whatever mix of goods and services it chooses and is thus an important means of
shifting an economy’s production possibilities curve rightward.

Allocative Efficiency
Technological advance as embodied in product (or service) innovation enhances
allocative efficiency by giving society a more preferred mix of goods and services.

1
Douglas F. Greer, Industrial Organization and Public Policy, 3rd ed. (New York: Macmillan, 1992),
pp. 680–687.
 chapter twelve • technology, r&d, and efficiency 323

Recall from our earlier discussion that consumers buy a new product rather than an
old product only when buying the new one increases the total utility obtained from
their limited income. Obviously, then, the new product—and the new mix of prod-
ucts it implies—creates a higher level of total utility for society.
In terms of markets, the demand for the new product rises and the demand for
the old product declines. The high economic profit engendered by the new product
attracts resources away from less-valued uses and to the production of the new
product. In theory, such shifting of resources continues until the price of the new
product equals its marginal cost.
There is a caveat here, however. Innovation (either product or process) can cre-
ate monopoly power through patents or through the many advantages of being first.
When new monopoly power results from an innovation, society may lose part of the
improved efficiency it otherwise would have gained from that innovation. The rea-
son is that the profit-maximizing monopolist restricts output to keep its product
price above marginal cost. Microsoft used an early innovation in computer software
(its DOS operating system) to achieve a commanding presence in some parts of the
software industry. It built its monopoly power partly on a strategy of continual,
identifiable product upgrades, from MS-DOS to Windows to Windows XP, with new
versions in between. These product improvements are often announced well in
advance, and the new versions contain more and more features of competing soft-
ware. Moreover, Microsoft has extended some of its monopoly power to related soft-
ware products (Word, PowerPoint). So although society has benefited greatly from
the surge of product improvements flowing from Microsoft, another result has been
rising entry barriers and monopoly in the software industry. Also, Microsoft contin-
ues to have economic profit far above the long-run normal profit associated with
allocative efficiency. Concerned about this inefficiency, a federal court in 2000 found
Microsoft guilty of violating U.S. antitrust laws and ordered it broken into two com-
peting firms. Microsoft has appealed the verdict and breakup order to a higher court.
Innovation can reduce or even destroy monopoly power by providing competi-
tion where previously none existed. Economic efficiency is enhanced when that hap-
pens, because the new competition helps push prices down closer to marginal cost
and minimum average total cost. Innovation that leads to greater competition
within an industry reduces the inefficiency associated with reduced restriction of
output and monopoly prices. In the Microsoft example, the new technology of the
Internet has, at least temporarily, reduced Microsoft’s dominance in some emerging
areas of the software industry. Specifically, firms such as Sun Microsystems have
pioneered new software relating to the Internet (Java programming language),
leaving Microsoft working hard to catch up. So, it is difficult to judge whether
Microsoft’s monopoly power has hindered or abetted innovation. At the time of the
Federal District Court antitrust verdict in 2000, Microsoft was spending $2 billion
per year on research.

creative Creative Destruction

destruction Innovation may even generate creative destruction, where the creation of new
The hypothesis that products and new production methods simultaneously destroys the monopoly
the creation of new
products and pro-
market positions of firms committed to existing products and old ways of doing
duction methods business. As stated many years ago by Joseph Schumpeter, who championed the
simultaneously view that
destroys the market
power of existing In capitalist reality … it is … competition from the new commodity, the new tech-
monopolies. nology, the new source of supply, the new type of business organization—
 324 Part Two • Microeconomics of Product Markets

competition which commands a decisive cost or quality advantage and which

strikes not at the margins of profits of the existing firms but at their foundation
and their very lives. This kind of competition is … so … important that it becomes
<www.asiaweek.com/ a matter of comparative indifference whether competition in the ordinary sense
asiaweek/magazine/ functions more or less promptly; the powerful lever that in the [very] long run
2000/0324/cover1.html> expands output and brings down prices is in any case made of other stuff.2
Creative
Destruction City Many examples of creative destruction exist: In the 1800s wagons, ships, and
barges were the only means of transporting freight until the railroads broke up their
monopoly; the dominant market position of the railroads was, in turn, undermined
by trucks, and, later, by airplanes. Movies brought new competition to live theatre,
at one time the only show in town, but movies were later challenged by television.
Vinyl long-playing (LP) records supplanted acetate 78-rpm phonograph records;
cassettes then challenged LP records; and compact discs undermined cassettes.
Now Internet music recording technology found on sites such as MP3 and Napster
threaten sales of traditional CDs. Aluminum cans and plastic bottles have displaced
glass bottles in many uses. E-mail has challenged the postal service.
According to Schumpeter, an innovator will automatically displace any monop-
olist that no longer delivers superior performance, but many contemporary econo-
mists think this notion reflects more wishful thinking than fact. In this view, the idea
that creative destruction is automatic
neglects the ability of powerful established firms to erect private storm shelters—
or lobby government to build public storm shelters for them—in order to shield
themselves from the Schumpeterian gales of creative destruction. It ignores the
difference between the legal freedom of entry and the economic reality deterring
the entry of potential newcomers into concentrated industries.3
That is, some dominant firms may be able to use strategies such as selective price-
cutting, buyouts, and massive advertising to block entry and competition from even
the most innovative new firms and existing rivals. Moreover, rent-seeking dominant
firms have been known to persuade government to give them tax breaks, subsidies,
and tariff protection that strengthen their market power.
In short, while innovation in general enhances economic efficiency, in some cases
<www.forbes.com/ it may lead to entrenched monopoly power. Further innovation may eventually
global/1998/1214/
0119038a.html>
destroy that monopoly power, but the process of creative destruction is neither auto-
Creative matic nor inevitable. However, rapid technological change, innovation, and effi-
Destruction 101 ciency clearly are not necessarily inconsistent with possession of monopoly power.

Consumer and Producer Surplus

and Efficiency
Recall from Chapter 2 that we defined allocative efficiency as the distribution of
resources among firms and industries to produce the goods and services most
wanted by consumers. It is attained when the output of each product’s marginal
cost (price) and marginal benefits are equal. Figure 2-2 demonstrated allocative

2
Joseph A. Schumpeter, Capitalism, Socialism, and Democracy, 3rd ed. (New York: Harper & Row,
1950), pp. 84–85.
3
Walter Adams and James Brock, The Structure of American Industry, 9th ed. (Englewood Cliffs,
NJ: Prentice-Hall, 1995), p. 310.
 chapter twelve • technology, r&d, and efficiency 325

efficiency using marginal cost–marginal benefits analysis. Productive efficiency is

attained when production is carried out in the least costly manner. For a firm pro-
ductive efficiency occurs at an output at which average total cost is at a minimum,
or when the marginal product per dollar’s worth of input is the same for all inputs.
In terms of Chapter 2’s production possibilities frontier, productive efficiency
implies a point on the production possibilities curve.

Consumer Surplus
Another way to understand allocative efficiency is through consumer surplus, briefly
consumer introduced in Chapter 9’s “The Last Word,” and producer surplus. Consumer surplus
surplus The is the difference between what a consumer (or consumers) is willing to pay for an addi-
difference between tional unit of a product or service and its market price. In almost all markets, consumers
what a consumer is
willing to pay for an
collectively obtain more utility (total satisfaction) from their purchases than the amount
additional unit of a of their expenditures (product price × quantity). The surplus of utility arises because
product or service some consumers are willing to pay more than the equilibrium price but need not do so.
and its market price. Consider the market for black denim jeans depicted in Figure 12-7. The demand
curve D tells us that at $70 no consumers are willing to buy black denim jeans, but
some consumers of black denim jeans are willing to pay more than the $50 market
price. For example, assume Vijay is willing to pay $65; Elise, $60; Dieter, $55; and
Andrea, in contrast, is unwilling to pay one penny more than the $50 market price.
There are many other consumers besides Vijay, Elise, and Dieter in this market
who are willing to pay prices above $50. Only Andrea pays exactly the price she is
willing to pay; the others receive some amount of utility beyond their expenditures.
The difference between that utility value (measured by the vertical height of the
points on the demand curve) and the $50 price is the consumer surplus. For exam-
ple, Vijay is willing to pay $65 for a pair of black denim jeans, but he only pays the
$50 market price, for a utility surplus of $15 (= $65 – 50). When we add together each

FIGURE 12-7 CONSUMER DEMAND AND CONSUMER SURPLUS

Consumers collec- P
tively obtain more
Price (per pair of black denim jeans)

utility from their

purchases of black $70
denim jeans than Total
consumer
their expenditure. 65 surplus
At $50, consumers
obtain a total con-
sumer surplus
Vijay’s consumer surplus
represented by the
blue triangle and pay Market Price
the amount repre-
sented by the grey 50
rectangle. Amount paid

D = MB

0 Q* Q
Quantity demanded
326 Part Two • Microeconomics of Product Markets

buyer’s utility surplus, we obtain the consumer surplus for all the consumers in the
market. To get the Q* of black denim jeans, consumers collectively are willing to pay
the sum of the amounts represented by the blue triangle and grey rectangle. How-
ever, consumers only have to pay the amount represented by the grey rectangle. The
blue triangle thus represents consumer surplus.
A glance at Figure 12-7 shows that the amount of consumer surplus—the size of
the blue triangle—would be less if the sellers could charge some price above $50. As
just one example, at a price of $65, only a very small triangle of consumer surplus
would exist. In imperfectly competitive markets in which firms are not price-takers,
consumer surplus would shrink. But if the $50 is the market-clearing price in a
purely competitive industry, firms cannot charge $65, because they are price-takers.
Any firm that charged a price above $65 would immediately lose all its business to
the other firms. Moreover, we know that in pure competition, the equilibrium price
equals the marginal cost of the Q* black denim jeans. And, since we are assuming
that entry and exit have resulted in this price being equal to lowest average total
cost, each seller is earning only a normal profit. By definition, this profit is just suf-
ficient to continue production of black denim jeans.
The principle that emerges is this: By establishing the lowest price consistent with
continued production, pure competition yields the largest sustainable amount of
consumer surplus. The further we are from pure competition, the smaller the con-
sumer surplus.

producer Producer Surplus

surplus The
difference between The idea of producer surplus is somewhat similar to consumer surplus. Producer
what producers surplus is the difference producers receive for a product or service less the marginal
receive for a prod-
uct or service and
cost of producing it. You will recall that the marginal cost curve is a firm’s supply
the marginal cost curve. Once again, let’s look at the market for black denim jeans, but this time we
of producing it. focus on the supply side. Figure 12-8 depicts the supply curve for black denim jeans

FIGURE 12-8 PRODUCER SUPPLY AND PRODUCER SURPLUS

At a price of $30 or P
less, no black denim
Price (per pair of black denim jeans)

jeans are supplied.

If Acme can supply
black denim jeans at S (∑MC)
$40 a pair but is able
to sell them at $50, Producer
Acme realizes a $10 surplus
producer surplus on Market price
each pair. Collec- $50
tively, producers Acme's
realize a producer producer
surplus represented surplus
by the blue triangle, 40
Cost of
while the shaded production
area under the supply
curve represents 30
the marginal cost of
producing black
denim jeans. 0 Q Q* Q
Quantity demanded
 chapter twelve • technology, r&d, and efficiency 327

with the same market price of $50 and quantity of Q*. Analogous to consumers will-
ing to pay different prices for black denim jeans, producers are willing to supply
black denim jeans at different prices, depending on their costs.
At $30 suppliers are not willing to offer any black denim jeans. But at any price
above $30 and below $50 per pair of jean, there is some producer surplus. For exam-
ple, if Acme Corporation is willing to offer Q1 of black denim jeans at $40, but the
market price is $50, the company would realize a producer surplus of $10 per pair
of jeans. At a $50 market price producers collectively will realize a producer surplus
represented by the blue triangle in Figure 12-8. The shaded area under the supply
curve represents the marginal cost of producing black denim jeans.

Efficiency Restated
Figure 12-9 brings together Figure 12-7 and 12-8. It depicts a market equilibrium in
a purely competitive industry. What is apparent is that at the equilibrium price and
quantity, the sum of consumer and producer surplus is maximized. Consumers are
getting just the number of black denim jeans they desire and value. Another way of
looking at it is that at equilibrium price, the willingness to pay equals the opportu-
nity cost of producing black denim jeans. At less than Q* fewer black denim jeans
and more of some other good, blue denim shirts, are produced that consumers value
less than black denim jeans. In a purely competitive industry, the price of black
denim jeans will rise, bringing about economic profit, which will bring in more
firms to produce black denim jeans. The production of more black denim jeans will
reduce their price, until marginal cost equals marginal benefit again. You will recall
that we arrived at the same conclusion in Chapter 2’s Figure 2-2. Allocative effe-
ciency is achieved when the marginal benefit to society of one more unit of black
denim jeans just equals the marginal cost of producing them.

FIGURE 12-9 EFFICIENCY AND THE MARKET FOR BLACK

DENIM JEANS
Economic resources P
are used efficiently
Price (per pair of black denim jeans)

when the sum of con- Consumer

sumer and producer $70 surplus
surpluses are maxi- S (MC)
mized. It is also the
price and quantity at
which MC = MB.
Consumer surplus
is depicted by the
green area below 50
the demand curve.
Producer surplus is
depicted by the blue
area above the sup- Producer
ply curve. surplus D (MB)
30

0 Q* Q
Quantity demanded
328 Part Two • Microeconomics of Product Markets

FIGURE 12-10 INEFFICIENCY AND DEADWEIGHT LOSS

At prices above the P
$50 equilibrium, for

Price (per pair of black denim jeans)

example, $60, con-
sumer surplus and $70
producer surplus are Deadweight S (MC)
not maximized. The loss
reduction is called 60
deadweight loss.
There is also dead-
weight loss to the
right of equilibrium. 50
Deadweight loss rises
as market price and
quantity move away
from equilibrium.
D (MB)
30

0 Q1 Q* Q
Quantity

Underproduction and Overproduction

Figure 12-10 depicts a situation in which the sum of consumer surplus and producer
surplus are not maximized. If production of black denim jeans were an oligopoly,
for example, the price could rise above $50 and production could be less than alloca-
tive efficiency requires. At a price of $60, only Q1 black denim jeans are produced.
At $60 per pair of black denim jeans, there is an underproduction or not enough
resources allocated to the production of black denim jeans. Economist call this
deadweight reduction of consumer surplus and producer surplus a deadweight loss. At $60 per
loss The loss of pair of black denim jeans, the marginal benefit is larger than the marginal cost, sig-
consumer surplus nalling that consumers value black denim jeans more than other alternative goods
and producer sur-
plus when output than can be produced with the scarce inputs.
is either below or Note that at prices below equilibrium, and thus production beyond Q*, consumer
above its efficient surplus and producer surplus will also not be maximized. To the right of Q* there
level. is an overallocation of resources, or the marginal cost of producing black denim
jeans is greater than the marginal benefits, indicating consumers do not value black
denim jeans as much as other products that could be produced with the scarce
inputs.
Consumer surplus and producer surplus, along with deadweight loss, allow
economists to easily measure winners and losers in markets. At a more macroeco-
nomic level, they can be used to help design public policy.

1945 Grace Murray Hopper finds
a dead moth between relay con-
tacts in the experimental Mark II
computer at Harvard University.
Whenever the computer subse-
quently malfunctions, workers
set out to debug the device.
1946 ENIAC is revealed. It is a
precursor to the modern-day
computer that relies on 18,000
vacuum tubes and fills 765 cubic
metres of space.
1947 AT&T scientists invent the
transfer resistance device, later
known as the transistor. It re-
places the less reliable vacuum
tubes in computers.
1961 Bob Noyce (who later
founded Intel Corporation) and
Jack Kilby invent the first inte-
grated circuit, which miniatur-
izes electronic circuitry onto a
single silicon chip.
1964 IBM introduces the Sys-
tem/360 computer. Configured
as a system, it takes up nearly
the same space as two tennis
courts.
1965 Digital Equipment Corpo-
ration unveils its PDP-8, the first
relatively small-sized computer
(a minicomputer).
1969 A networking system called
ARPANET is born; it is the begin-
ning of the Internet.
1971 Intel introduces its 4004
processor (a microprocessor).
The $200 chip is the size of
a thumbnail and has as much
chapter twelve • technology, r&d, and efficiency
ON THE PATH TO THE PERSONAL
COMPUTER AND INTERNET
Technological advance is clearly evident in the development
of the modern personal computer and the emergence of
the Internet. Here is a brief history of those events.
computing capability as the 1946
ENIAC.
1975 Xerox markets Alto, the
first personal computer (a micro-
computer). Bill Gates and Paul
Allen found Microsoft. MITS
Corporation’s Altair 8800 arrives
on the scene. It contains Intel’s
8080 microprocessor that Intel
developed a year earlier to con-
trol traffic lights.
1977 Apple II, Commodore’s
PET, and Tandy Radio Shack
TRS-80 go on sale, setting the
stage for the personal computer
revolution.
1981 IBM enters the market with
its personal computer powered
by the Intel 8800 chip and oper-
ated by the Microsoft Disc Oper-
ating System (MS-DOS). Os-
borne Computer markets the
Osborne 1, the first self-
contained microcomputer, but
within two years the firm de-
clares bankruptcy. Logitech com-
mercializes the X-Y Position Indi-
cator for a Display System,
invented earlier by Douglas En-
gelbart in a government-funded
research lab. Someone dubs it a
329
computer mouse because it ap-
pears to have a tail.
1982 Compaq Computer clones
the IBM machines; others do the
same. Eventually Compaq be-
comes the leading seller of per-
sonal computers.
1984 Apple introduces its Mac-
intosh computer, with its user-
friendly icons, attached mouse,
and preloaded software. College
student Michael Dell founds Dell
Computers, which builds per-
sonal computers and sells them
through mail order. IBM, Sears
Roebuck, and CBS team up to
launch Prodigy Services, the first
online computer business.
1985 Microsoft releases its Win-
dows graphical user interface
operating system that improves
on MS-DOS. Ted Waitt starts a
mail-order personal computer
business (Gateway 2000) out of
his South Dakota barn.
1990 Microsoft introduces Win-
dows 3.0 which, like Macintosh,
features windows, icons, and pull-
down menus. Apple sues Micro-
soft for copyright infringement.
1991 The World Wide Web (an
Internet system) is invented.
1993 Intel introduces its first
of several Pentium chips, which
greatly speed up computing.
The courts reject Apple’s claim
that Microsoft violated its copy-
rights on its Macintosh operat-
ing system.
330 Part Two • Microeconomics of Product Markets

1994 Marc Andreessen starts up
Netscape Communications and
markets Netscape Navigator,
which quickly becomes the lead-
ing software browser for the
emerging Internet. David Filo
and Jerry Yang develop Yahoo,
a system for locating material
stored on the Internet.
1995 Microsoft releases Win-
dows 95 operating system, which
becomes the dominant operat-
ing system of personal comput-
ers (90 percent market share).
Microsoft is now well estab-
lished as the world’s leading
software producer. Sun Micro-
systems introduces Java, an In-
ternet programming language.
1996 Playing catch-up with
Netscape, Microsoft develops
Microsoft Internet Explorer and
gives it away free.
1999 Netscape’s market share
plunges and it merges with
American Online. More than 100
million personal computers are
manufactured worldwide in this
year alone.
2000 A federal court rules that
Microsoft is an abusive monop-
oly and orders it broken into two
companies, one that sells is op-
erating system and another that
sells its applications. Microsoft
appeals the case to a higher
court. Half of American house-
holds are online and the Internet
emerges as a major technologi-
cal revolution worldwide. Inter-
net commerce in the United
States reaches $300 billion and
an estimated 1.2 million U.S.
jobs are Internet-related.
Source: Based partly on Diedtra
H e n d e r s o n , “ M o o r e ’s L a w S t i l l
Reigns,” Seattle Times, Nov. 24, 1996.
Augmented and updated.

chapter summary
1. Technological advance is evidenced by new
and improved goods and services and new
and improved production or distribution
processes. In economists’ models, technolog-
ical advance occurs only in the very long run.
2. Invention is the discovery of a product or
process through the use of imagination,
ingenuity, and experimentation. Innovation
is the first successful commercial introduc-
tion of a new product, the first use of a new
method, or the creation of a new form of
business enterprise. Diffusion is the spread
of an earlier innovation among competing
firms. Firms channel a majority of their R&D
expenditures to innovation and imitation,
rather than to basic scientific research and
invention.
3. Historically, most economists viewed tech-
nological advance as a random, external
force to which the economy adjusted. Many
contemporary economists see technological
advance as occurring in response to profit
incentives within the economy and thus as
an integral part of capitalism.
4. Entrepreneurs and other innovators try to
anticipate the future. They play a central role in
technological advance by initiating changes in
products and processes. Entrepreneurs often
form start-up firms that focus on creating and
introducing new products. Sometimes, inno-
vators work in the R&D labs of major corpora-
tions. Entrepreneurs and innovative firms
often rely heavily on the basic research done
by university and government scientists.
5. A firm’s optimal amount of R&D spending
occurs where its expected return (marginal
benefit) from R&D equals its interest-rate
cost of funds (marginal cost) to finance R&D.
Entrepreneurs and firms use several sources
to finance R&D, including (a) bank loans,
(b) bonds, (c) venture capital (funds lent in
return for a share of the profits if the busi-
ness succeeds), (d) undistributed corporate
profits (retained earnings), and (e) personal
savings.
6. Product innovation, the introduction of new
products, succeeds when it provides con-
sumers with higher marginal utility per
 chapter twelve • technology, r&d, and efficiency 331

dollar spent than existing products do. The
new product enables consumers to obtain
greater total utility from a given income.
From the firm’s perspective, product innova-
tion increases net revenue sufficiently to
yield a positive rate of return on the R&D
spending that produced the innovation.
7. Process innovation can lower a firm’s pro-
duction costs by improving its internal pro-
duction techniques. Such improvement
increases the firm’s total product, thereby
lowering its average total cost and increas-
ing its profit. The added profit provides a
positive rate of return on the R&D spending
that produced the process innovation.
8. Imitation poses a potential problem for inno-
vators, since it threatens their returns on
R&D expenditures. Some dominant firms
use a fast-second strategy, letting smaller
firms initiate new products and then quickly
imitating the successes. Nevertheless, sig-
nificant protections and potential benefits go
to firms that take the lead with R&D and
innovation, including (a) patent protection,
(b) copyrights and trademarks, (c) lasting
brand-name recognition, (d) benefits from
trade secrets and learning by doing, (e) high
economic profits during the time lag
between a product’s introduction and its imi-
tation, and (f) the possibility of lucrative buy-
out offers from larger firms.
9. Each of the four basic market structures has
potential strengths and weaknesses regard-
ing the likelihood of R&D and innovation.
The inverted-U theory holds that a firm’s
R&D spending as a percentage of its sales
rises with its industry four-firm concentra-
tion ratio, reaches a peak at a 50 percent
concentration ratio, and then declines as
concentration increases further. Empirical
evidence is not clear-cut but lends general
support to this theory. For any specific indus-
try, however, the technological opportunities
that are available may count more than mar-
ket structure in determining R&D spending
and innovation.
10. In general, technological advance enhances
both productive and allocative efficiency.
But in some situations patents and the
advantages of being first with an innovation
can increase monopoly power. While in
some cases creative destruction eventually
destroys monopoly, most economists doubt
that this process is either automatic or
inevitable.
11. Consumer surplus is the difference between
what a consumer is willing to pay for an
additional unit of a product or service and its
market price. Producer surplus is the differ-
ence producers receive for a product or serv-
ice less the marginal cost of producing it.
Efficiency in a market is realized when the
sum of consumer surplus and producer sur-
plus is maximized. Reductions in consumer
surplus and producer surplus from their
maximums is referred to as deadweight loss.

terms and concepts

technological advance,
p. 305
very long run, p. 305
invention, p. 305
patent, p. 305
innovation, p. 305
product innovation, p. 306
process innovation, p. 306
diffusion, p. 306
start-ups, p. 308
venture capital, p. 310
interest-rate cost-of-funds
curve, p. 310
expected-rate-of-return curve,
p. 311
optimal amount of R&D, p. 312
imitation problem, p. 316
fast-second strategy, p. 317
inverted-U theory of R&D,
p. 321
creative destruction, p. 323
consumer surplus, p. 325
producer surplus, p. 326
deadweight loss, p. 328

study questions
1. What is meant by technological advance, as
broadly defined? How does technological
advance enter into the definition of the very
long run? Which of the following are exam-
ples of technological advance, and which are
not: an improved production process; entry
of a firm into a profitable purely competitive
industry; the imitation of a new production
process by another firm; an increase in a
firm’s advertising expenditures?
332 Part Two • Microeconomics of Product Markets
2. Listed below are several possible actions by
firms. Write INV beside those that reflect
invention, INN beside those that reflect in-
novation, and DIF beside those that reflect
diffusion.
a. An auto manufacturer adds heated seats
as a standard feature in its luxury cars to
keep pace with a rival firm whose luxury
cars already have this feature.
b. A television production company pio-
neers the first music video channel.
c. A firm develops and patents a working
model of a self-erasing whiteboard for
classrooms.
d. A light bulb firm is the first to produce
and market lighting fixtures with halogen
lamps.
e. A rival toy maker introduces a new Jenny
doll to compete with Mattel’s Barbie doll.
3. Contrast the older and modern views of
technological advance as they relate to the
economy. What is the role of entrepreneurs
and other innovators in technological
advance? How does research by universi-
ties and government affect innovators and
technological advance? Why do you think
some university researchers are becoming
more like entrepreneurs and less like pure
scientists?
4. KEY QUESTION Suppose a firm
expects that a $20 million expenditure on
R&D will result in a new product that will
increase its revenue by a total of $30 million
one year from now. The firm estimates that
the production cost of the new product will
be $29 million.
a. What is the expected rate of return on
this R&D expenditure?
b. Suppose the firm can get a bank loan at
6 percent interest to finance its $20 mil-
lion R&D project. Will the firm undertake
the project? Explain why or why not.
c. Now suppose the interest-rate cost of
borrowing, in effect, falls to 4 percent
because the firm decides to use its own
retained earnings to finance the R&D.
Will this lower interest rate change the
firm’s R&D decision? Explain.
5. KEY QUESTION Answer the lettered
questions in the next column on the basis of
the information in this table:
Amount of R&D, Expected rate of
millions return on R&D, %
$10 16
$20 14
$30 12
$40 10
$50 8
$60 6
a. If the interest-rate cost of funds is 8 per-
cent, what will be the optimal amount of
R&D spending for this firm?
b. Explain why $20 million of R&D spending
will not be optimal.
c. Why won’t $60 million be optimal either?
6. KEY QUESTION Refer to Table 12-1
and suppose the price of new product C is
$2 instead of $4. How does this affect the
optimal combination of products A, B, and C
for the person represented by the data?
Explain: “The success of a new product
depends not only on its marginal utility but
also on its price.”
7. Learning how to use software takes time. So
once customers have learned to use a par-
ticular software package, it is easier to sell
them software upgrades than to convince
them to switch to new software. What impli-
cations does this have for expected rates of
return on R&D spending for software firms
developing upgrades versus firms develop-
ing imitative products?
8. KEY QUESTION Answer the follow-
ing questions on the basis of this informa-
tion for a single firm: total cost of capital =
$1000; price paid for labour = $12 per labour
unit; price paid for raw materials = $4 per
raw-material unit.
a. Suppose the firm can produce 5000 units
of output by combining its fixed capital
with 100 units of labour and 450 units of
raw materials. What are the total cost and
average total cost of producing the 5000
units of output?
b. Now assume the firm improves its pro-
duction process so that it can produce
6000 units of output by combining its
fixed capital with 100 units of labour and
450 units of raw materials. What are the
total cost and average cost of producing
the 6000 units of output?
 chapter twelve • technology, r&d, and efficiency
c. Refer to your answers to 8a and 8b and
explain how process innovation can im-
prove economic efficiency.
9. Why might a firm making a large economic
profit from its existing product employ a
fast-second strategy in relationship to new
or improved products? What risks does it run
in pursuing this strategy? What incentive
does a firm have to engage in R&D when
rivals can imitate its new product?
10. Do you think the overall level of R&D would
increase or decrease over the next 20 to 30
years if the lengths of new patents were
extended from 17 years to, say, forever?
What if the duration were reduced from 17
years to, say, 3 years?
11. Make a case that neither pure competition
nor pure monopoly is conducive to a great
deal of R&D spending and innovation. Why
internet application question
1. Visit NASA’s Technology Transfer Office
<www.sti.nasa.gov/tto> to determine where
significant commercial benefits have been
realized from secondary use of NASA tech-
nology. Are there any that have been inconse-
333
might oligopoly be more favourable to R&D
spending and innovation than either pure
competition or pure monopoly? What is the
inverted-U theory and how does it relate to
your answers to these questions?
12. Evaluate: “Society does not need laws
outlawing monopolization and monopoly.
Inevitably, monopoly causes its own self-
destruction, since its high profit is the lure
for other firms or entrepreneurs to develop
substitute products.”
13. Distinguish between consumer surplus and
producer surplus. What is deadweight loss
and how does it relate to consumer surplus
and producer surplus?
14. (The Last Word) Identify a specific example
of each of the following in “The Last Word”:
(a) entrepreneurship, (b) invention, (c) inno-
vation, and (d) diffusion.
quential? How does the NASA Commercial
Technology Network <nctn.hq.nasa.gov/>
move technology from the lab to the market-
place?
 THIRTEEN

Competition
Policy and
Regulation
n the spirit of the TV show “Who Wants

I
●
to be a Millionaire?” try to answer these
questions.

Which one of the following companies

was found guilty of violating Canadian
IN THIS CHAPTER anti-combines laws: (a) Napster, (b) Micro-
Y OU WILL LEARN: soft, (c) Lafarge, (d) Colgate-Palmolive.
Final answer?
What industrial
concentration is. ● Business firms subject to industrial reg-
• ulation are often called (a) unnatural
About the evolution of monopolies, (b) monopolistic competitors,
Canadian competition
(c) monopsonists, (d) public utilities. Final
(anti-combines) policy
and its current aims. answer?
•
● The requirement that businesses make
The definition of social
regulations and what reasonable accommodations for disabled
their goals are. workers and customers is an example of
• (a) anti-combines policy; (b) an externality;
What a natural monopoly is
(c) social regulation; (d) economies of scale.
and why governments
regulate natural monopolies. Final answer?

The answer, in order, are (c), (d), and (c).

 chapter thirteen • competition policy and regulation 335

In this chapter we look at three sets of government policies toward business: anti-
combines policy, industrial regulation, and social regulation. Anti-combines policy
consists of the laws and government actions designed to prevent monopoly and pro-
mote competition. Industrial regulation consists of government regulation of firms’
prices (or rates) within selected industries. Social regulation is government regula-
tion of the conditions under which goods are produced, the physical characteristics
of goods, and the impact of the production and consumption of goods on society.

Definition of Industrial Concentration

In Chapter 10 we developed and applied a strict definition of monopoly. A pure
monopoly, we said, is a one-firm industry—a situation whereby a unique product is
being produced entirely by a single firm and entry to the industry is totally blocked.
In this chapter we will use the term industrial concentration to include pure
monopoly and markets in which much potential monopoly power exists. Industrial
concentration occurs whenever a single firm or a small number of firms control the
major portion of the output of an industry. One, two, or three firms dominate the
industry, potentially resulting in higher-than-competitive prices and profits. This
definition, which is closer to how the general public understands the monopoly
problem, includes many industries we have previously designated as oligopolies.
Industrial concentration in this chapter thus refers to industries in which firms
are large in absolute terms and in relation to the total market. Examples are the tele-
phone equipment industry, in which Nortel, large by any standard, dominates the
market; the automobile industry, where General Motors of Canada, Ford of Canada,
and DaimlerChrysler Canada are dominant; the chemical industry, dominated by
Petro-Canada, Imperial Oil (Exxon), and Shell Canada; the aluminum industry,
where industrial giant Alcan Aluminum reigns supreme; and the steel industry,
where the two large producers, Dofasco, formerly Dominion Foundries & Steel, and
Stelco, formerly Steel Company of Canada, command the lion’s share of the market.

The Anti-Combines Laws

The underlying purpose of anti-combines policy (antimonopoly policy) is to pre-
The Role of
Governments vent industrial concentration or monopolization, to promote competition, and to
achieve allocative efficiency. Although all economists would agree that these are
meritorious goals, conflicting opinions exist about the effectiveness of Canadian
anti- anti-combines policy. As we will see, anti-combines policy over the years has been
combines neither clear-cut nor consistent.
policy The laws
and government
actions designed to Historical Background
prevent monopoly
and promote
With the advent of Confederation in 1867, local markets began to widen into
competition. national markets because of improved transportation facilities, mechanized pro-
duction methods, and sophisticated corporate structures. In the 1880s and 1890s car-
tels emerged in several industries, including the cotton textile, salt, twine, flour,
canning and packing, and tobacco industries.
Firms often used questionable tactics to monopolize these industries and then
charged monopoly prices to customers and extracted price concessions from resource
suppliers. Farmers and owners of small businesses were particularly vulnerable to
the power of large corporate monopolies and were among the first to oppose them.
Consumers, labour unions, and economists were not far behind in their opposition.
 336 Part Two • Microeconomics of Product Markets

The main economic case against monopoly is familiar to you from Chapter 10.
Monopolists tend to produce less output and charge higher prices than if their
industries were competitive. With pure competition, production occurs where P =
MC. This equality represents an efficient allocation of resources because P measures
the marginal benefit to society of an extra unit of output, while marginal cost MC
reflects the cost of an extra unit. When P = MC, society cannot gain by producing
one more or one less unit of the product. In contrast, a monopolist maximizes profit
by equating marginal revenue (not price) with marginal cost. At this MR = MC
point, price exceeds marginal cost, meaning that society would obtain more benefit
than it would incur cost by producing extra units. There is an underallocation of
resources to the monopolized product, and so the economic well-being of society is
less than it would be with greater competition.
Government concluded in the late nineteenth century that market forces in
monopolized industries did not provide sufficient control to protect consumers,
achieve fair competition, and achieve allocative efficiency. So, it instituted two
alternative means of control as substitutes for, or supplements to, market forces.
anti- ● Regulatory agencies In the few markets where the nature of the product or
combines technology creates a natural monopoly, the government established public reg-
(anti-
monopoly) ulatory agencies to control economic behaviour.
legislation ● Anti-combines laws In most other markets, social control took the form of
Laws designed to
prevent the growth anti-combines (antimonopoly) legislation designed to inhibit or prevent the
of monopoly. growth of monopoly.
We will shortly review the anti-combines legislation that, as refined and extended
by various amendments, constitutes the basic law of the land with respect to cor-
porate size and concentration. Before we do, let’s examine merger types.

Merger Types
<www.iln.com/articles/
canada.html#12>
Three basic types of mergers can occur, as represented in Figure 13-1. This figure
Foreign investment shows two stages of production, one the input stage, the other the final-good stage
and anti-combines law of two distinct final-good industries: autos and blue jeans. Each rectangle (A, B, C
… X, Y, Z) represents a particular firm.
horizontal A horizontal merger is a merger between two competitors selling similar prod-
merger A ucts in the same market. In Figure 13-1 this type of merger is shown as a combina-
merger between two
competitors selling tion of glass producers T and U. Examples of horizontal mergers would be the
similar products in buyout of Eatons by Sears and Air Canada’s merger with Canadian Airlines.
the same market. A vertical merger is a merger between firms at different stages of the production
vertical process. In Figure 13-1 the merger between firm Z, a denim fabric producer, and firm
merger The F, a blue jeans producer, is a vertical merger. Vertical mergers involve firms having
merger of firms buyer–seller relationships. Examples of mergers of this type are PepsiCo’s mergers
engaged in different with Pizza Hut, Taco Bell, and Kentucky Fried Chicken. PepsiCo supplies soft
stages of produc- drinks to each of these fast-food outlets.
tion process of a
final product.
A conglomerate merger is officially defined as any merger that is not horizontal or
vertical; in general, it is the combination of firms in different industries or firms oper-
conglomer- ating in different geographical areas. Conglomerate mergers can extend the line of
ate merger products sold, or combine totally unrelated companies. In Figure 13-1, the merger
The merger of a firm
in one industry with
between firm C, an auto manufacturer, and firm D, a blue jeans producer, is a con-
a firm in another glomerate merger. A real-world example of a conglomerate is Power Corporation of
industry or region. Canada, headquartered in Montreal. Among its holdings are Great-West Life Co., Inc.,
 chapter thirteen • competition policy and regulation 337

FIGURE 13-1 TYPES OF MERGERS

Horizontal mergers Automobiles Blue jeans
(T + U) bring together
Conglomerate merger
firms selling the same
product in the same
geographical market;
vertical mergers Blue
(F + Z) connect firms Autos A B C D E F jeans
having a buyer–seller
relationship; and con-
glomerate mergers
(C + D) join firms in
different industries
or firms operating in Glass T U V W X Y Z Denim
fabric
different geographi-
cal areas.

Horizontal merger Vertical merger

a life insurance subsidiary, and Power Broadcast Inc., a subsidiary that owns news-
papers and radio stations. In Europe, Power Corporation has investments in major
communications, industrial, energy, utility, financial services, and food companies.
We now turn to look at the evolution of anti-combines legislation in Canada.

The Evolution of Anti-Combines Legislation

THE ACT OF 1889
Canadian anti-combines legislation began in 1889 with the passage of an Act that
made it a misdemeanour to conspire to restrict either trade, output, or competition.
Three years later, the Act of 1889 became a section of the Criminal Code and the
offence became an indictable one. In the first ten years of the twentieth century there
were six prosecutions under the section, resulting in four convictions. Securing evi-
dence to get a conviction under the Criminal Code was particularly difficult, and
further changes became necessary.

COMBINES INVESTIGATION ACT, 1910

combines The result was the passing of the Combines Investigation Act in 1910, an Act whose
investiga- name was changed in June 1986, when it became the Competition Act. The 1910 Act
tion act The authorized a judge, on receiving an application by six persons, to order an investi-
Act, in 1910, that
authorized a judge,
gation into an alleged combine.
on receiving an The 1910 Act was unsuccessful for two reasons: (1) rarely could six private citi-
application by six zens be found willing to bear the publicity and expense of initiating an investiga-
people, to order an tion; (2) each investigation, if and when ordered by a judge, started afresh; no
investigation into person or body administered the Act continuously. Thus, there was only one inves-
an alleged combine;
became the Compe-
tigation under the Act before World War I.
tition Act in 1986. The next 50 years saw no fundamental change. Of note were the 1952 amend-
ments to the Act, which split the duties of the combines commissioner and assigned
them to two separate agencies—one for investigation and research, the other for
appraisal and report. Thus were established a director of investigation and research
338 Part Two • Microeconomics of Product Markets

and a Restrictive Trade Practices Commission, the latter being superseded in June
1986 by the Competition Tribunal (see below).
In 1960, the Combines Investigation Act was at last amended to include the pro-
visions relating to combinations that had been laid down in the Criminal Code since
1892. As well, mergers and monopolies now were deemed unlawful only if a
“detriment or against the interest of the public.”
In 1967, the newly formed Department of Consumer and Corporate Affairs took
over responsibility for combines, mergers, monopolies, and restraint of trade.
Shortly thereafter, in 1969, the Economic Council of Canada reported that the pro-
visions of the Combines Investigation Act making mergers and monopolies crimi-
nal offences were “all but inoperative” because a criminal offence had to be proved
“beyond a shadow of a doubt”—a very difficult task. However, the Economic Coun-
cil did not recommend barriers be placed in the way of a company achieving dom-
inance through internal growth or superior efficiency. The Economic Council’s
whole approach then was based on the goal of economic efficiency. It was this same
approach that led the Economic Council to recommend that competition policy be
extended to services.
On January 1, 1976, new amendments to the Combines Investigation Act became
effective, with the result that it became applicable to services as well.

THE COMPETITION ACT, 1986

Successive governments in Ottawa have attempted to bring about changes to
Canada’s law governing monopolies. Three attempts, Bills brought before Parlia-
ment in 1971, 1977, and 1977–79, met with opposition from business. Extensive con-
sultations with the private sector and provincial governments preceded the
introduction of yet another Bill in 1984. The 1984 election intervened and this Bill,
competition too, was never enacted.
act The Act that Finally, in June 1986, Parliament passed the Competition Tribunal Act and the
replaced the Com- Competition Act, the latter being the new name for the Combines Investigation Act.
bines Investigation Some of the major changes are worth noting.
Act in 1986.
Civil Law Framework Uncompetitive market structures (monopoly and oligopoly)
competition and uncompetitive structural change (merger) now come under the jurisdiction of
tribunal A the civil law, making it easier to prosecute those mergers and monopolies not in the
government body
that adjudicates public interest. Some behaviour, such as price fixing, is still handled by the regular
under a civil law courts, where the standard of evidence is “beyond a reasonable doubt” and the
framework that per- penalties are harsh. A competition tribunal adjudicates under a civil law frame-
mits the issuing of work that permits the issuing of remedial orders to restore and maintain competi-
remedial orders to
restore and main-
tion in the market. The tribunal is made up of judges of the Federal Court and
tain competition in laypersons, with a judge as chairperson. The Restrictive Trade Practices Commis-
the market. sion was abolished as a result.
Two additional points can be made. The Competition Act does not directly attack
monopoly; nothing is wrong with having 100 percent of the market. But abuse of a
monopoly position can be attacked.

Recent Cases
<canada.justice.gc.ca/ The Competition Act is designed to achieve economic efficiency and to be adaptable
en/laws/C-36.4/ to changing market conditions and international trade. Only those mergers result-
index.html>
Competition Tribunal
ing in an unacceptable lessening of competition can be prohibited or modified by
Act (R.S. 1985, c. 19 the competition tribunal. Mergers that result in efficiency gains through capturing
[2nd Supp.]) economies of scale have generally been allowed.
 chapter thirteen • competition policy and regulation 339

The Competition Bureau recommended allowing the merger of Air Canada and
Canadian Airlines in 1999, provided the federal government opened up the Cana-
dian market to foreign competition. Canadian Airlines was in financial difficulty
and it was doubtful that it could survive on its own. Much can be said for the merger
of Air Canada and Canadian Airlines on efficiency grounds, but concern is justified
among the public about market concentration unless the federal government decides
to pursue the so-called open skies policy.
The Competition Bureau recommended against chartered bank mergers in 1998,
when the Royal Bank of Canada and the Bank of Montreal announced their intention
to merge. Soon after, the Canadian Imperial Bank of Commerce and the Toronto Domin-
ion Bank also decided to merge. The banks argued that they needed to merge to cap-
ture economies of scale and be able to compete internationally. The Competition Bureau
was not convinced by the banks’ argument, citing fears that competition would be
greatly curtailed in smaller centres for both consumers and small and medium-sized
firms. The Bureau noted that even if more foreign banks were allowed to compete in the
<strategis.ic.gc.ca/
Canadian market, the large established network of branches by the Canadian banks
SSG/ct01250e.html> provided a large barrier to entry for any new competitor. The Royal Bank of Canada and
Competition Bureau the Bank of Montreal were, however, successful in merging their credit card operations.

Issues of Enforcement: Tradeoffs among Goals

Promoting competition is only one of society’s goals and strict enforcement of the anti-
combines laws may sometimes conflict with some other goal. Here are two examples.

BALANCE OF TRADE
Government seeks ways to increase exports to pay for imports. Anti-combines
actions that undo a merger between two chemical suppliers, or dissolve a microchip
or software monopolist, might weaken the targeted firm, thereby reducing its com-
petitiveness and sales abroad. Consequently, Canadian exports might decline and
thus create or increase the nation’s trade deficit. Should government strictly enforce
anti-combines laws, even when significant amounts of Canadian exports are at
stake? Or should the anti-combines goal of efficiency be superseded by the goal of
balancing exports and imports?

EMERGING NEW TECHNOLOGIES

Occasionally, new technologies combine to create new products and services. A cur-
rent example is the meshing of computer and communications technologies relat-
ing to the Internet. This interactive network has improved the communications
capabilities of households, businesses, and governments across the globe. It also
enables people to access unprecedented amounts of information and directly buy
and sell goods and services. The emergence of this new technology has set off a
spate of megamergers among entertainment companies, telecommunication com-
panies, computer manufacturers, and software producers.
Should the government strictly enforce anti-combines laws to block some of those
mergers, specifically ones that produce dominant firms and threaten to reduce com-
petition? Or should the government temporarily suspend anti-combines rules to
encourage the restructuring of industries and speed the expansion of this new tech-
nology? Hastening the advance of Internet-related technologies might also increase
Canadian exports of electronic services.
Each of these enforcement tradeoffs, by itself, triggers controversy. Some argue
that the gains from an anti-combines policy must be weighed against the effects of
340 Part Two • Microeconomics of Product Markets

the policy on conflicting objectives. Others contend that selective enforcement of

anti-combines laws dangerously interferes with the market process. Obviously, dif-
ferent policymakers and different administrations may view such considerations
and tradeoffs differently. (Key Question 2 and 3)

● Industrial concentration exists where a single
firm or a small number of firms control the
major portion of an industry’s output.
● Three types of mergers can occur: horizontal,
vertical, and conglomerate.
● The first Canadian anti-combines legislation
was passed in 1889. Its purpose was to make it
unlawful to restrict competition unduly.
● The original anti-combines legislation subse-
quently came under the Criminal Code, making
successful prosecution difficult.
● The Competition Act, passed in 1986, removed
anti-combines activity from the Criminal Code,
making prosecution easier. This Act also stressed
that even if some mergers lessen competition,
they should be allowed if such mergers bring
about significant efficiency gains.

Industrial Regulation
Anti-combines policy assumes that society will benefit if monopoly is prevented
The Role of
Governments from evolving or if it is dissolved where it already exits. We now return to a special
situation in which an economic reason exists for an industry to be organized
monopolistically.

Natural Monopoly
natural A natural monopoly exists when economies of scale are so extensive that a single
monopoly An firm can supply the entire market at a lower unit cost than could a number of com-
industry in which peting firms. Clear-cut circumstances of natural monopoly are relatively rare, but
economies of scale
are so extensive
such conditions exist for many public utilities, such as local electricity, water, and nat-
that a single firm ural gas. As we discussed in Chapter 10, large-scale operations in some cases are
can supply the necessary to obtain low unit costs and a low product price. Where natural monop-
entire market at a oly exists, competition is uneconomical. If the market were divided among many
lower unit cost than producers, economies of scale would not be achieved and unit costs and prices
could a number of
competing firms.
would be higher than necessary.
There are two possible alternatives for promoting better economic outcomes
public where natural monopoly exists. One is public ownership, and the other is public
interest regulation.
theory of Public ownership or some approximation of it has been established in a few
regulation instances, such as Canada Post and CN at the national level and mass transit, water
The theory that
industrial regulation supply systems, and garbage collection at the local level.
is necessary to keep But public regulation, or what economists call industrial regulation, has been the
a natural monopoly preferred option in Canada. In this type of regulation, government commissions
from charging regulate the prices (usually called rates) charged by natural monopolists. Table 13-1
monopoly prices
and thus harming
lists the major federal regulatory commissions and their jurisdictions.
consumers and The economic objective of industrial regulation is embodied in the public inter-
society. est theory of regulation. According to that theory, industrial regulation is necessary
to keep a natural monopoly from charging monopoly prices and thus harming con-
sumers and society. The goal of such regulation is to garner for society at least part
 chapter thirteen • competition policy and regulation 341

of the cost reductions associated with natural

TABLE 13-1 THE MAIN monopoly while avoiding the restrictions of
FEDERAL output and high prices that come with unregu-
REGULATORY lated monopoly. If competition is inappropriate
AGENCIES or impractical, society should allow or even
encourage a monopoly but regulate its prices.
Atomic Energy Control Board
Regulation should then be structured so that
Canadian Dairy Commission ratepayers benefit from the economies of
Canadian Grain Commission scale—the lower per-unit costs—that natural
Canadian Radio-Television and monopolists are able to achieve.
Telecommunications Commission In practice, regulators seek to establish rates
Canadian Wheat Board that will cover production costs and yield a fair
National Energy Board return to the enterprise. The goal is to set price
equal to average total cost, so that the regulated
National Farm Products Marketing Council
firm receives a normal profit, as described in the
National Harbours Board “Regulated Monopoly” section of Chapter 10.
National Transport Agency of Canada In particular, you should carefully review Fig-
ure 10-9.

Problems with Industrial Regulation

Considerable disagreement rages over the effectiveness of industrial regulation.
Let’s examine two criticisms.

COSTS AND INEFFICIENCY

An unregulated firm has a strong incentive to reduce its costs at each level of out-
put, because that will increase its profit. The regulatory commission, however, con-
fines the regulated firm to a normal profit or a fair return on the value of its assets.
If a regulated firm lowers its operating costs, the rising profit eventually will lead
the regulatory commission to require the firm to lower its rates and return its prof-
its to normal. The regulated firm, therefore, has little or no incentive to reduce its
operating costs.
Worse yet, higher costs do not result in lower profit. Because the regulatory com-
missions must allow the public utility a fair return, the regulated monopolist can
simply pass through higher production costs to consumers by charging higher rates.
A regulated firm may reason that it might as well have high salaries for its workers,
opulent working conditions for management, and the like, since the return is the
same in percentage terms whether costs are minimized or not. So, although a natu-
ral monopoly reduces cost through economies of scale, industrial regulation fosters
considerable X-inefficiency (Figure 10-7). Because of the absence of competition, the
potential cost savings from natural monopoly may never actually materialize.

PERPETUATING MONOPOLY
A second general problem with industrial regulation is that it sometimes perpetu-
ates monopoly long after the conditions of natural monopoly have evaporated.
Technological change often creates the potential for competition in at least some
or all portions of the regulated industry, such as when trucks began competing with
railroads; transmission of voice and data by microwave and satellites began com-
peting with transmission over telephone wires; satellite television began competing
with cable television, and cell phones began competing with regular phones. But,
spurred by the firms they regulate and believing that the regulated firms are natural
342 Part Two • Microeconomics of Product Markets

monopolies, commissions often protect the regulated firms from new competition by
either blocking entry or extending regulation to competitors. The rationale usually
is that the competitors simply want to skim the cream from selected highly profitable
portions of the regulated industry but do no want to offer the universal service
required of the regulated firm. By losing the highly profitable portion of their busi-
ness, the regulated firms would have to increase rates for services that do not pay
their own way to continue to receive a fair rate of return on their assets.
But where regulators block entry or extend regulation to competitive firms,
industrial regulation may perpetuate a monopoly that is no longer a natural
monopoly and that would otherwise erode. Ordinary monopoly, protected by gov-
ernment, may then supplant natural monopoly. If so, then the regulated prices may
be higher than they would be with competition. The beneficiaries of outdated reg-
ulations are the regulated firms, their employees, and perhaps consumers of some
services. The losers are all other consumers and the potential competitors who are
barred from entering the industry. (Key Question 8)

Legal Cartel Theory

legal The regulation of potentially competitive industries has produced the legal cartel
cartel theory of regulation. In place of socially minded officials forcing regulation on nat-
theory of ural monopolies to protect consumers, holders of this view see practical politicians
regulation as supplying regulation to local, regional, and national firms that fear the impact of
The hypothesis that
some industries competition on their profits or even on their long-term survival. These firms desire
seek regulation or regulation because it yields a legal monopoly that can guarantee a profit. Specifi-
want to maintain cally, the regulatory commission performs such functions as blocking entry (for
regulation so that example, in local telephone service), or, where there are several firms, the commis-
they may form a
legal cartel.
sion divides up the market much like an illegal cartel (for example, before airline
deregulation, the federal government assigned routes to specific airlines). The com-
mission may also restrict potential competition by enlarging the “cartel.”
Although private cartels are illegal, unstable, and often break down, the special
attraction of a government-sponsored cartel under the guise of regulation is that it
endures. The legal cartel theory of regulation suggests that regulation results from the
rent-seeking activities of private firms and the desire of politicians to be responsive.
Occupational licensing is a labour-market application of the legal cartel theory.
Certain occupational group—barbers, dentists, hairstylists, interior designers, dieti-
tians, lawyers—demand stringent licensing on the grounds that it protects the pub-
lic from charlatans and quacks, but skeptics say the real reason may be to limit entry
into the occupational group so that practitioners can receive monopoly incomes. It
is not surprising to these skeptics that a recent study found that, other things equal,
<csgb.ubc.ca/ccpp/>
dental fees were about 15 percent higher and dentist income 10 percent higher in
Canadian areas with the most restrictive licensing laws. The quality of dentistry apparently
competition policy was not affected.1

Deregulation
Beginning in the 1970s, the legal cartel theory, evidence of inefficiency in regulated
industries, and the contention that the government was regulating potentially

1
Morris Kleiner and Robert Kudrie, “Does Regulation Affect Economic Outcomes? The Case of
Dentistry,” Journal of Law and Economics, October 2000, pp. 547–582.
 chapter thirteen • competition policy and regulation 343

competitive industries all contributed to a wave of deregulation. Since then, Parlia-

ment and some provincial legislatures have passed legislation that has deregulated
in varying degrees the airline, trucking, banking, railroad, natural gas, electricity,
and television broadcasting industries. Deregulation has also occurred in the
telecommunications industry. Bell Canada now competes with other carriers, such
as Sprint, in the local and long-distance markets. Bell Canada also competes with
cellular companies. Deregulation in the 1970s and 1980s was one of the most exten-
sive experiments in economic policy to take place during the past 50 years.

Controversy
Deregulation was controversial, and the nature of the controversy was predictable.
Proponents of deregulation, basing their arguments on erosion of natural monop-
oly and the legal cartel theory, contended that deregulation would lower prices,
increase output, and eliminate bureaucratic inefficiencies.
Some critics of deregulation, embracing the view of continued natural monopoly
and the public interest theory, argued that deregulation would result in destructive
price wars and eventual re-monopolization of some of the deregulated industries by
a single firm. They predicted higher prices, diminished output, and deteriorating
service. Other critics were concerned that deregulation would lead to industry
instability and that vital services (for example, transportation) would be withdrawn
from smaller communities, while some stressed that as increased competition
reduced the revenues of each firm, firms would lower their safety standards to
reduce costs and remain profitable.

Outcomes of Deregulation
While there are still come critics of deregulation, most economists believe that
deregulation has clearly benefited consumers and the economy. According to stud-
ies, deregulation of formerly regulated industries is now contributing hundreds of
millions of dollars annually to society’s well-being through lower prices, lower
costs, and increased output.2 Most of those gains are accruing in three industries:
airlines, railroads, and trucking. Airfares (adjusted for inflation) have declined by
about one-third, and airline safety has improved. Trucking and railroad freight rates
(again, adjusted for inflation) have dropped by about one-half. Significant effi-
ciency gains have occurred in long-distance telecommunications, and slight effi-
ciency gains have been made in cable television, stock brokerage services, and the
natural gas industry. Deregulation has unleashed a wave of technological advances
that have resulted in such new and improved products and services as fax
machines, cellular phones, fibre-optic cable, microwave systems in communica-
tions, and the Internet.
<sanjose.bcentral.com/ The success of past deregulation has led to further calls for deregulation. The
sanjose/stories/1998/ latest industry to begin the deregulation process is electricity, led by Alberta and
01/19/editorial4.html> Ontario. Deregulation is now occurring at the wholesale level, where firms are free
The United States can
learn a few lessons
to build generating facilities and sell electricity at market prices. The federal gov-
on deregulation from ernment’s goal is for all consumers to have a choice among competing power sup-
Canada’s moves pliers by 2010.

2
Clifford Winston, “Economic Deregulation: Days of Reckoning for Microeconomists,” Journal of
Economic Literature, September 1993, p. 1284; and Robert Crandall and Jerry Ellig, Economic
Deregulation and Consumer Choice, Center for Market Processes, Fairfax, Virginia, 1997.
344 Part Two • Microeconomics of Product Markets

● Natural monopoly occurs where economies of
scale are so extensive that only a single firm
can produce the product at minimum average
total cost.
● The public interest theory of regulation says that
government must regulate natural monopo-
lies to prevent abuses arising from monopoly
power. Regulated firms, however, have less
incentive than competitive firms to reduce costs;
that is, regulated firms tend to be X-inefficient.
● The legal cartel theory of regulation suggests that
some firms seek government regulation to re-
duce price competition and ensure stable profits.
● Deregulation initiated by government in the
past three decades has yielded large annual
efficiency gains for society.

Social Regulation
The industrial regulation discussed in the preceding section has focused on the reg-
The Role of
Governments ulation of prices (or rates) in natural monopolies. But in the early 1960s, a new type
of regulation began to emerge. Social regulation is concerned with the conditions
under which goods and services are produced, the impact of production on society,
social and the physical qualities of the goods themselves.
regulation
Government regula-
tion of the condi- Distinguishing Features
tions under which Social regulation differs from industrial regulation in several ways.
goods are pro-
duced, the physical
First, social regulation applies to far more firms than industrial regulation. Social
characteristics of regulation is often applied across the board to all industries and directly affects more
goods, and the producers than does industrial regulation. For instance, while the industrial regula-
impact of the pro- tion by the Air Transport Committee of the National Transport Agency of Canada
duction on society. controls only the air transport industry, the rules and regulations of the Canada
Labour (Safety) Code and its provincial counterparts apply to every employer.
Second, social regulation intrudes into the day-to-day production process to a
greater extent than industrial regulation. While industrial regulation focuses on
rates, costs, and profits, social regulation often dictates the design of products, the
conditions of employment, and the nature of the production process. As examples,
rather than specify safety standards for vehicles, the Motor Vehicle Safety Act
includes six standards limiting motor vehicle exhaust and noise emission.
Finally, social regulation has expanded rapidly during the same period in which
industrial regulation has waned. Under this social regulation, firms must provide
reasonable accommodations for qualified workers and job applicants with disabili-
ties. Also, sellers must provide reasonable access for customers with disabilities. As
much of our society had achieved a fairly affluent standard of living by the 1960s,
attention shifted to improvement in the nonmaterial quality of life. That focus
called for safer products, less pollution, improved working conditions, and greater
equality of economic opportunity.

The Optimal Level of Social Regulation

While economists agree on the need for social regulation, they disagree on whether
the current level of such regulation is optimal. Recall that an activity should be
expanded so long as its marginal benefit (MB) exceeds its marginal cost (MC). If the
 chapter thirteen • competition policy and regulation 345

MB of social regulation exceeds its MC, then there is too little social regulation, but,
if MC exceeds MB, there is too much social regulation. Unfortunately, the marginal
costs and benefits of social regulation are not always easy to measure and therefore
may be illusive. So, ideology about the proper size and role of government often
drives the debate over social regulation as much as, or perhaps more than, economic
cost–benefit analysis.

IN SUPPORT OF SOCIAL REGULATION

Defenders of social regulation say that it has achieved notable successes and, over-
all, has greatly enhanced society’s well-being. They point out that the problems
social regulation confronts are serious and substantial. Thousands of workers die
annually in job-related accidents and millions of workers suffer injuries that force
them to miss a day or more of work. Air pollution continues to cloud major Cana-
dian cities, imposing large costs in terms of reduced property values and increased
health care expense. Numerous children and adults die each year because of poorly
designed or manufactured products (for example, car tires) or tainted food (for
example, e-coli in beef). Discrimination against some ethnic minorities, persons
with disabilities, and older workers reduces their earnings and imposes heavy costs
on society.
Proponents of social regulation acknowledge that social regulation is costly, but
they correctly point out that a high price for something does not necessarily mean
that it should not be purchased. They say that the appropriate economic test should
not be whether the costs of social regulation are high or low but whether the bene-
fits of social regulation exceed the costs. After decades of neglect, they further assert,
society cannot expect to cleanse the environment, enhance the safety of the work-
place, and promote economic opportunity for all without incurring substantial
costs. So statements about the huge costs of social regulation are irrelevant, say
defenders, since the benefits are even greater. The public often underestimates
those benefits, since they are more difficult to measure than costs and often become
apparent only after some time has passed (for example, the benefits of reducing
global warming).
Proponents of social regulation point to its many specific benefits. It is esti-
mated that highway fatalities would be 40 percent greater annually in the absence
of auto safety features mandated through regulation. Compliance with child safety-
seat and seat belt laws has significantly reduced the auto fatality rate for small
children. The national air quality standards set by law have been reached in nearly
all parts of the nation for sulphur dioxide, nitrogen dioxide, and lead. Recent
studies clearly link cleaner air, other things equal, with increases in the values
of homes. Employment equity regulations have increased the labour demand for
ethnic minorities and females. The use of childproof lids has resulted in a 90
percent decline in child deaths caused by accidental swallowing of poisonous
substances.
Some defenders of social regulation say many areas remain in which greater reg-
ulation would generate net benefits to society. For example, some call for greater
regulation of the meat, poultry, and seafood industries to improve food safety. Oth-
ers say that more regulation is needed to ensure that violent movies, CDs, and video
games are not marketed to children.
Advocates of social regulation say that the benefits of such regulation are well
worth the considerable costs. The costs are simply the price we must pay to create
a hospitable, sustainable, and just society. (Key Question 10)
346 Part Two • Microeconomics of Product Markets

Criticisms of Social Regulation

Critics of social regulation contend that, in many instances, it has been expanded to
the point where the marginal costs exceed the marginal benefits. In this view, soci-
ety would achieve net benefits by cutting back on meddlesome social regulation.
Critics say that many social regulation laws are poorly written, making regulatory
objectives and standards difficult to understand. As a result, regulators pursue goals
well beyond the original intent of the legislation. Businesses complain that regula-
tors often press for additional increments of improvement, unmindful of costs.
Finally, opponents of social regulation say that the regulatory agencies may
attract overzealous workers who are hostile toward the market system and believe
too fervently in regulation. For example, some Environment Canada staff allegedly
see all pollution as bad and all polluters as “bad guys.” They have been accused of
avoiding the challenge of trying to identify the optimal amount of pollution based
on a careful analysis of marginal costs and marginal benefits.

Two Reminders
The debate over the proper amount of social regulation will surely continue. We
leave both proponents and opponents of social regulation with pertinent economic
reminders.

THERE IS NO FREE LUNCH

On the one hand, fervent supporters of social regulation need to remember that
there is no free lunch. Social regulation can produce higher prices, stifle innovation,
and reduce competition.
Social regulation raises product prices in two ways. It does so directly because
compliance costs normally get passed on to consumers, and it does so indirectly by
reducing labour productivity. Resources invested in making workplaces accessible
to workers with disabilities, for example, are not available for investment in new
machinery designed to increase output per worker. Where the wage rate is fixed, a
drop in labour productivity increases the marginal and average total costs of pro-
duction. In effect, the supply curve for the product shifts leftward, causing the price
of the product to rise.
Social regulation may have a negative impact on the rate of innovation. Techno-
logical advance may be stifled by, say, the fear that a new plant will not meet Envi-
ronment Canada’s guidelines or that a new medicine will require years of testing
before being approved by the federal government.
Social regulation may weaken competition, since it usually places a relatively
greater burden on small firms than on large ones. The costs of complying with social
regulation are, in effect, fixed costs. Because smaller firms produce less output over
which to distribute those costs, their compliance costs per unit of output put them
at a competitive disadvantage with their larger rivals. Social regulation is more
likely to force smaller firms out of business, thus contributing to the increased con-
centration of industry.

LESS GOVERNMENT IS NOT ALWAYS BETTER THAN MORE

On the other hand, fervent opponents of social regulation need to remember that
less government is not always better than more government. Although the market
system is a powerful engine for producing goods and services and generating
income, it has its flaws. Through social regulation government can clearly increase
 chapter thirteen • competition policy and regulation 347

economic efficiency and thus society’s well-being. Ironically, by taking the rough
edges off of capitalism, social regulation may be a strong pro-capitalist force. Prop-
erly conceived and executed, social regulation helps maintain political support for
the market system. Such support could quickly wane if there is a steady stream of
reports of unsafe workplaces, unsafe products, discriminatory hiring, choking pol-
lution, ill-served medical patients, and the like. Social regulation helps the market
system deliver not only goods and services but also a “good society.”

● Social regulation is concerned with the condi-
tions under which goods and services are pro-
duced, the effects of production on society,
and the physical characteristics of the goods
themselves.
● Defenders of social regulation point to the
benefits arising from policies that keep danger-
ous products from the marketplace, reduce
workplace injuries and deaths, contribute to
clean air and water, and reduce employment
discrimination.
● Critics of social regulation say uneconomical
policy goals, inadequate information, unintended
side effects, and overzealous personnel create
excessive regulation, for which regulatory costs
exceed regulatory benefits.

THE MICROSOFT ANTITRUST CASE

The Charges
In May 1998 the U.S. Justice De-
partment, 19 individual states,
and the District of Columbia
(hereafter, “the government”)
filed antitrust charges against
Microsoft under the Sherman
Antitrust Act. The government
charged that Microsoft had vio-
lated Section 2 of the Act by tak-
ing a series of unlawful actions
designed to maintain its Win-
dows brand monopoly. The gov-
ernment also charged that some
of those specific actions violated
Section 1 of the Sherman Act.
Microsoft denied the charges,
arguing that it had achieved its
success through product innova-
tion and lawful business prac-
In 2000 a U.S. District Court found Microsoft guilty of
violating the Sherman Act, a U.S. anti-combines law.
What were the specific findings? What remedy did
the Court propose?
tices. Microsoft argued that it Microsoft used anticompetitive
should not be penalized for its su- means to maintain and broaden
perior foresight, business acu- its monopoly power.
men, and technological prowess. According to the Court, Mi-
It also pointed out that its monop- crosoft feared that the success of
oly was highly transitory because Netscape’s Navigator, which al-
of rapid technological advance. lowed people to browse the In-
ternet, might allow Netscape to
The Findings expand its software to include
In June 2000 the District Court a competitive PC operating
ruled that the relevant market system—software that would
was that of software used to op- threaten the Windows monop-
erate Intel-compatible personal oly. It also feared that Sun’s In-
computers (PCs). Microsoft’s 95 ternet applications of its Java
percent share of that market programming language might
clearly gave it monopoly power. eventually threaten Microsoft’s
The Court pointed out, however, Windows monopoly.
that being a monopoly is not To counter these and similar
illegal. The violation of the threats, Microsoft illegally tied
Sherman Act occurred because Internet Explorer (Microsoft’s
348 Part Two • Microeconomics of Product Markets

Internet browser) to Windows
and provided Internet Explorer
at no charge. It also signed con-
tracts with PC makers that re-
quired them to feature Internet
Explorer on the PC desktop and
penalized companies that pro-
moted software products that
competed with Microsoft prod-
ucts. Moreover, it gave friendly
companies coding that linked
Windows to software applica-
tions and withheld it from com-
panies featuring Netscape. Fi-
nally, under licence from Sun,
Microsoft developed Windows-
related Java software that made
Sun’s own software incompati-
ble with Windows.
The Court concluded:
Microsoft mounted a deliber-
ate assault upon entrepre-
neurial efforts, that, left to rise
or fall on their own merits
could well have enabled the
introduction of competition
into the market for Intel-
compatible PC operating sys-
tems.… More broadly, Micro-
soft’s anticompetitive actions
trammeled the competitive
process through which the
software industry generally
stimulates innovation and con-
duces to the optimum benefit
of consumers.*
The Remedy
The District Court ordered that
Microsoft be split into two com-
panies, one selling the Windows
operating system and the other
selling Microsoft applications
(such as Word, Excel, Hotmail,
MSN, PowerPoint, and Internet
Explorer). Also, both companies
are expressly prohibited from
entering into joint ventures with
one another, licensing or selling
products to one another at more
favourable terms than those
given to other firms, or engaging
in any activities that Microsoft
used to thwart competition and
maintain its monopoly. Both
companies are free, however, to
develop new products that com-
pete with each other, and both
can derive those products from
the intellectual property embod-
ied in the common products ex-
isting at the time of the divesti-
ture. The rights to Internet
Explorer, however, reside with
the applications company.
The Appeal
Stunned by the verdict and the
perceived harshness of the rem-
edy, in late 2000 Microsoft ap-
pealed the District Court deci-
sion to a U.S. Court of Appeals.
Microsoft claimed that the gov-
ernment had not proved its case
and that District Court Judge
Thomas Jackson evidenced bias
against Microsoft throughout
the case. A decision from the Ap-
peals Court was still pending at
the time of publication of this
book. We urge you to research
the status of the Microsoft case
via an Internet search.
Sources: United States v. Microsoft
(Conclusions of Law, April 2000;
Final Order, June 2000) and Reuters
New Service.
*United States v. Microsoft (Conclu-
sions of Law), April 2000, p. 9.

chapter summary
1. Mergers can be of three types: horizontal, ver-
tical, and conglomerate.
2. The cornerstone of anti-combines policy con-
sists of amendments to the Criminal Code in
1892 and the Combines Investigation Acts of
1910 and 1923. On the fifth attempt, the Com-
petition Act was finally passed in mid-1986,
supplanting the Combines Investigation Act.
3. The objective of industrial regulation is to pro-
tect the public from the market power of nat-
ural monopolies by regulating prices and
quality of service.
4. Critics of industrial regulation contend that it
can lead to inefficiency and rising costs and
that in many instances it constitutes a legal
cartel for the regulated firms. Legislation
passed in the late 1970s and the 1980s has
brought about varying degrees of dereg-
ulation in the airline, trucking, banking, rail-
road, and television broadcasting industries.
 chapter thirteen • competition policy and regulation 349

Studies indicate that deregulation is produc-
ing sizable annual gains to society through
lower prices, lower costs, and increased out-
put. The latest Canadian industries to begin
the deregulation process are electricity and
natural gas.
5. Social regulation in concerned with product
safety, working conditions, and the effects of
production on society. Whereas industrial
regulation is on the wane, social regulation
continues to expand. The optimal amount of
social regulation is where MB = MC.
6. Those who support social regulation point to
its numerous specific successes and assert that
it has greatly enhanced society’s well-being.
Critics of social regulation contend that busi-
nesses are excessively regulated to the point
where marginal costs exceed marginal bene-
fits. They also say that social regulation often
produces unintended and costly side effects.

terms and concepts

anti-combines policy, p. 335
anti-combines (antimonopoly)
legislation, p. 336
horizontal merger, p. 336
vertical merger, p. 336
conglomerate merger, p. 336
Combines Investigation Act,
p. 337
Competition Act, p. 338
Competition Tribunal, p. 338
natural monopoly, p. 340
public interest theory of
regulation, p. 340
legal cartel theory of
regulation, p. 342
social regulation, p. 344

study questions
1. Both anti-combines policy and industrial pol-
icy deal with monopoly. What distinguishes
their approach? How does government de-
cide to use one form of remedy rather than
the other?
2. KEY QUESTION Explain how strict
enforcement of the anti-combines laws
might conflict with (a) promoting exports to
achieve a balance of trade, and (b) encour-
aging new technologies. Do you see any
dangers in using selective anti-combines
enforcement as part of a broader policy to
increase exports?
3. KEY QUESTION How would you
expect anti-combines authorities to react to
(a) a proposed merger of Ford and General
Motors; (b) evidence of secret meetings by
contractors to rig bids for highway construc-
tion projects; (c) a proposed merger of a
large shoe manufacturer and a chain of retail
shoe stores; and (d) a proposed merger of a
small life-insurance company and a regional
candy manufacturer.
4. Suppose a proposed merger of firms would
simultaneously lessen competition and
reduce unit costs through economies of
scale. Do you think such a merger should be
allowed?
5. In the 1980s, PepsiCo Inc., which then had 28
percent of the soft-drink market, proposed to
acquire the 7-Up Company. Shortly there-
after the Coca-Cola Company, with 39 per-
cent of the market, indicated it wanted to
acquire the Dr. Pepper Company. Seven-Up
and Dr. Pepper each controlled about 7 per-
cent of the market. In your judgment, was
the government’s decision to block these
mergers appropriate?
6. “The anti-combines laws tend to penalize
efficiently managed firms.” Do you agree?
Why or why not?
7. “The social desirability of any particular firm
should be judged not on the basis of its mar-
ket share but on the basis of its conduct and
performance.” Make a counterargument,
referring to the monopoly model in your
statement.
8. KEY QUESTION What types of indus-
try, if any, should be subjected to industrial
regulation? What specific problems does
industrial regulation entail?
9. In view of the problems involved in regulat-
ing natural monopolies, compare socially
optimal (marginal-cost) pricing and fair-
return pricing by referring again to Figure
10-9. Assuming that a government subsidy
might be used to cover any loss resulting
350 Part Two • Microeconomics of Product Markets
from marginal-cost pricing, which pricing
policy would you favour? Why? What prob-
lems might such a subsidy entail?
10. KEY QUESTION How does social
regulation differ from industrial regulation?
What types of benefits and costs are associ-
ated with social regulation?
11. Use economic analysis to explain why the
optimal amount of product safety may be
less than the amount that would totally elim-
inate risks of accidents and deaths. Use auto-
mobiles as an example.
internet application question
1. Visit Canada’s Competition Tribunal’s Web
site at <www.ct-tc.gc.ca/english/current.html>.
Review the current filings. What companies
does the latest filing include? Scroll down to
12. (The Last Word) Under what law and on
what basis did the U.S. federal govern-
ment find Microsoft guilty of violating U.S.
antitrust laws? What was the government’s
proposed remedy? In mid-2000 Microsoft
appealed the District Court decision to a
higher court. Update the Microsoft story,
using an Internet search engine. What is the
current status of that appeal? Is it still pend-
ing? Did Microsoft win its appeal? Or was the
District Court’s decision upheld?
“Decision Rendered.” Review the case of the
Bank of Montreal. On what basis did the Com-
missioner of Competition make its decision?
 FOURTEEN

The Demand
for Resources

W
e now turn from the pricing and

production of goods and services

to the pricing and employment of

resources. Although firms come in various

sizes and operate under highly different mar-

IN THIS CHAPTER ket conditions, they each have a demand

Y OU WILL LEARN:
for productive resources. They obtain those
How resource prices
are determined. resources from households—the direct or
•
indirect owners of land, labour, capital, and
What determines the
demand for a resource.
entrepreneurial resources. So, referring to
•
What determines the the circular flow model (Figure 2-6), we shift
elasticity of resource demand.
• our attention from the bottom loop of the
How to arrive at the optimal
combination of resources to diagram (where businesses supply products
use in the production process.
that households demand) to the top loop

(where businesses demand resources that

households supply).
 chapter fourteen • the demand for resources 353

This chapter looks at the demand for economic resources. Although the discussion is
couched in terms of labour, the principles we develop also apply to land, capital,
and entrepreneurial ability. In Chapter 15 we will combine resource (labour)
demand with labour supply to analyze wage rates. Then in Chapter 16 we will use
resource demand and resource supply to examine the prices of, and returns to, other
productive resources.

Significance of Resource Pricing

There are several good reasons to study resource pricing:
● Money-income determination Resource prices are a major factor in deter-
mining the income of households. The expenditures that firms make in acquir-
ing economic resources flow as wage, rent, interest, and profit incomes to the
households that supply those resources.
● Resource allocation Just as product prices allocate finished goods and serv-
ices to consumers, resource prices allocate resources among industries and
firms. In a dynamic economy, where technology and tastes often change,
the efficient allocation of resources over time calls for the continuing shift of
resources from one use to another. Resource pricing is a major factor in pro-
ducing those shifts.
● Cost minimization To the firm, resource prices are costs, and to realize max-
imum profit, the firm must produce the profit-maximizing output with the
most efficient (least costly) combination of resources. Resource prices play the
main role in determining the quantities of land, labour, capital and entrepre-
neurial ability that will be combined in producing each good or service.
● Ethical questions and policy issues Many ethical questions and public policy
issues surround the resource market. What degree of income inequality is accept-
<www.rci.rutgers.edu/ able? Should the government levy a special tax on the excess pay of corporate ex-
~gag/NOTES/
micnotes11.html>
ecutives? Should the federal government establish a legal minimum wage? Does
Marginal productivity it make sense for the government to provide subsidies to farmers? The facts, ethics,
theory of distribution and debates relating to income distribution are all based on resource pricing.

Marginal Productivity Theory

of Resource Demand
Choosing
To make things simple, we will first assume that a firm hires a certain resource in a
a Little More purely competitive resource market and sells its output in a purely competitive
or Less
product market. The simplicity of this situation is twofold: In a competitive prod-
uct market the firm is a price-taker and can dispose of as little or as much output as
it chooses at the market price. The firm is selling such a negligible fraction of total
output that it exerts no influence on product price. Similarly, in the competitive
resource market, the firm is a wage-taker. It hires such a negligible fraction of the
derived total supply of the resource that it cannot influence the resource price.
demand
The demand for
a resource that Resource Demand as a Derived Demand
depends on the
products it can be The demand for resources is a derived demand: it is derived from the products that
used to produce. those resources help produce. Resources usually do not directly satisfy customer
354 Part Three • Microeconomics of Resource Markets

wants but do so indirectly through their use in producing goods and services. No one
wants to consume a hectare of land, a John Deere tractor, or the labour services of a
farmer, but households do want to consume the food and fibre products that these
resources help produce. Similarly, the demand for airplanes generates a demand for
assemblers, and the demands for such services as income-tax preparation, haircuts,
and child care create derived demands for accountants, barbers, and child-care work-
ers. Global Perspective 14.1 demonstrates that the global demand for labour is derived.

Marginal Revenue Product (MRP)

The derived nature of resource demand means that the strength of the demand for
any resource will depend on
● the productivity of the resource in helping to create a good
● the market value or price of the good it helps to produce
A resource that is highly productive in turning out a highly valued commodity will
be in great demand, while a relatively unproductive resource that is capable of pro-
ducing only a slightly valued commodity will be in little demand. There will be no
demand at all for a resource that is phenomenally efficient in producing something
that no one wants to buy.

PRODUCTIVITY
Table 14-1 shows the roles of productivity and product price in determining
resource of demand. Here, we assume that a firm adds one variable resource,
labour, to its fixed plant. Columns 1 and 2 give the number of units of the resource

14.1

Percentage of Labour Force

Labour demand and
0 25 50 75 100
allocation: developing
countries, industrially Agriculture
Developing
advanced countries, countries Industry
and Canada Services

The idea of derived demand Agriculture

Industrially
implies that the composition advanced Industry
countries Services
of a country’s product-market
demand will determine the allo- Agriculture
cation of its labour force among Canada Industry
agricultural products, industrial Services
goods, and services. Because
lower-income nations must spend most of their incomes on food and fibre,
the bulk of their labour is allocated to agriculture. The industrially advanced
economies with higher incomes allocate most of their labour to industrial
products and services.
Source: International Labour Organization data, <www.ilo.org>.
 chapter fourteen • the demand for resources 355

TABLE 14-1 THE DEMAND FOR LABOUR: PURE COMPETITION

IN THE SALE OF THE PRODUCT
(1) (2) (3) (4) (5) (6)
Units of Total Marginal Product Total Marginal
resource product product, MP price revenue, or revenue
(output) (2) × (4) product, MRP

0 0 $2 $ 0
7 $14
1 7 2 14
6 12
2 13 2 26
5 10
3 18 2 36
4 8
4 22 2 44
3 6
5 25 2 50
2 4
6 27 2 54
1 2
7 28 2 56

applied to production and the resulting total product (output). Column 3 provides
marginal the marginal product (MP), or additional output, resulting from each additional
product resource unit. Columns 1 through 3 remind us that the law of diminishing returns
(MP) The extra applies here, causing the marginal product of labour to fall beyond some point. For
output produced
with one additional
simplicity, we assume that those diminishing marginal returns—those declines in
unit of a resource. marginal product—begin after the first worker hired.

PRODUCT PRICE
The derived demand for a resource depends also on the price of the commodity it
produces. Column 4 in Table 14-1 adds this price information. Product price is con-
stant, in this case at $2, because we are assuming a competitive product market. The
firm is a price-taker and will sell units of output only at this market price.
Multiplying column 2 by column 4 gives us the total-revenue data of column 5.
These are the amounts of revenue the firm realizes from the various levels of
marginal resource usage. From these total-revenue data we can compute marginal revenue
revenue product (MRP), the change in total revenue resulting from the use of each addi-
product tional unit of a resource (labour, in this case). In equation form,
(MRP) The
change in total change in total revenue
revenue from Marginal revenue product = ᎏᎏᎏᎏᎏ
one unit change in resource quantity
employing one
additional unit of The MRPs are listed in column 6 in Table 14-1.
a resource.

Rule for Employing Resources: MRP = MRC

The MRP schedule, shown as columns 1 and 6, is the firm’s demand schedule for labour. To
explain why, we must first discuss the rule that guides a profit-seeking firm in hir-
ing any resource: To maximize profit, a firm should hire additional units of a specific
resource as long as each successive unit adds more to the firm’s total revenue than it adds to
total cost.
Economists use special terms to designate what each additional unit of labour or
other variable resource adds to total cost and what it adds to total revenue. We have
seen that MRP measures how much each successive unit of a resource adds to total
356 Part Three • Microeconomics of Resource Markets

revenue. The amount that each additional unit of a resource adds to the firm’s total
marginal (resource) cost is called its marginal resource cost (MRC).
resource In equation form,
cost (MRC)
The amount that change in total (resource) cost
each additional unit
Marginal resource cost = ᎏᎏᎏᎏᎏ
one unit change in resource quantity
of resource adds
to the firm’s total So we can restate our rule for hiring resources as follows: It will be profitable for
(resource) cost. a firm to hire additional units of a resource up to the point at which that resource’s
MRP is equal to its MRC. If the number of workers a firm is currently hiring is such
that the MRP of the last worker exceeds his or her MRC, the firm can profit by hir-
ing more workers. But if the number being hired is such that the MRC of the last
worker exceeds his or her MRP, the firm is hiring workers who are not paying their
way, and it can increase its profit by discharging some workers. You may have rec-
mrp = mrc ognized that this MRP = MRC rule is similar to the MR = MC profit-maximizing
rule To maxi- rule employed throughout our discussion of price and output determination. The
mize economic rationale of the two rules is the same, but the point of reference is now inputs of a
profit (or minimize
losses) a firm
resource, not outputs of a product.
should use the
quantity of a MRP as Resource Demand Schedule
resource at which
its marginal rev- In a purely competitive labour market, supply and demand establish the wage rate.
enue product is Because each firm hires such a small fraction of market supply, it cannot influence
equal to its mar- the market wage rate; it is a wage-taker, not a wage-maker. This means that for each
ginal resource cost.
additional unit of labour hired, total resource cost increases by exactly the amount
of the constant market wage rate. The MRC of labour exactly equals the market
wage rate. Thus, resource “price” (the market wage rage) and resource “cost” (mar-
ginal resource cost) are equal for a firm that hires a resource in a competitive labour
market. Then the MRP = MRC rule tells us that, in pure competition, the firm will hire
workers up to the point at which the market wage rate (its MRC) is equal to its MRP.
<cepa.newschool.edu/ In terms of the data in columns 1 and 6 in Table 14-1, if the market wage rate is,
het/essays/margrev/ say, $13.95, the firm will hire only one worker, because the first worker adds $14 to
distrib.htm#marginal> total revenue and slightly less—$13.95—to total cost. In other words, because MRP
Marginal productivity
theory of distribution
exceeds MRC for the fist worker, it is profitable to hire that worker. For each suc-
cessive worker, however, MRC (= $13.95) exceeds MRP (= $12 or less), indicating
that it will not be profitable to hire any of those workers. If the wage rate is $11.95,
by the same reasoning we discover that it will pay the firm to hire both the first and
second workers. Similarly, if the wage rate is $9.95, three will be hired. If $7.95, four.
If $5.95, five. And so forth. Hence, the MRP schedule constitutes the firm’s demand for
labour, because each point on this schedule (or curve) indicates the number of workers the
firm would hire at each possible wage rate. In Figure 14-1, we show the D = MRP curve
based on the data in Table 14-1.
The logic here will be familiar to you: In Chapter 9 we applied the price-equals-
marginal-cost (P = MC) rule for profit-maximizing output to discover that the por-
tion of the purely competitive firm’s short-run marginal-cost curve lying above
the AVC curve is the short-run product supply curve. Here, we are applying the
MRP = MRC (= resource price) rule for profit-maximizing input to discover that
the purely competitive firm’s MRP curve is its resource demand curve.

Resource Demand under Imperfect Product Market Competition

Our analysis of labour demand becomes more complex when the firm is selling its
product in an imperfectly competitive market, one in which the firm is a price-
 chapter fourteen • the demand for resources 357

FIGURE 14-1 THE PURELY COMPETITIVE SELLER’S DEMAND

FOR A RESOURCE
The MRP curve is the P
resource demand curve;

Resource price (wage rate)

each of its points relates a
particular resource price $14
(= MRP when profit is maxi- 12
mized) with a corresponding
quantity of the resource 10
demanded. Under pure 8
competition, product price D = MRP
is constant; therefore, the 6
downward slope of the D = 4
MRP curve is due solely to
the decline in the resource’s 2
marginal product (law of
diminishing marginal 0 1 2 3 4 5 6 7 8 Q
returns). Quantity of resource demanded

maker. Pure monopoly, oligopoly, and monopolistic competition in the product

market all mean that the firm’s product demand curve is downsloping; the firm
must set a lower price to increase its sales.
The productivity data in Table 14-1 are retained in columns 1 to 3 in Table 14-2.
But here we show in column 4 that product price must be lowered to sell the mar-
ginal product of each successive worker. The MRP of the purely competitive seller
of Table 14-1 falls for one reason: marginal product diminishes. The MRP of the
imperfectly competitive seller of Table 14-2 falls for two reasons: marginal product
diminishes and product price falls as output increases.
We emphasize that the lower price accompanying each increase in output (total
product) applies not only to the marginal product of each successive worker but also

TABLE 14-2 THE DEMAND FOR LABOUR: IMPERFECT

COMPETITION IN THE SALE OF THE PRODUCT
(1) (2) (3) (4) (5) (6)
Units of Total Marginal Product Total Marginal
resource product product, MP price revenue, or revenue
(output) (2) × (4) product, MRP

0 0 $2.80 $ 0
7 $18.20
1 7 2.60 18.20
6 13.00
2 13 2.40 31.20
5 8.40
3 18 2.20 39.60
4 4.40
4 22 2.00 44.00
3 2.25
5 25 1.85 46.25
2 1.00
6 27 1.75 47.25
1 –1.05
7 28 1.65 46.20
358 Part Three • Microeconomics of Resource Markets

to all prior output units that otherwise could have been sold at a higher price. Note that
the second worker’s marginal product is six units. These six units can be sold for
$2.40 each, or, as a group, for $14.40. But this is not the MRP of the second worker.
To sell these six units, the firm must take a 20-cent price cut on the seven units
produced by the first worker—units that otherwise could have been sold for $2.60
each. Thus, the MRP of the second worker is only $13.00 [= $14.40 – (7 × 20 cents)],
as shown.
Similarly, the third worker adds five units to total product, and these units are
worth $2.20 each, or $11.00 total. But to sell these five units the firm must take a 20-
cent price cut on the 13 units produced by the first two workers. So the third
worker’s MRP is only $8.40 [= $11.00 – (13 × 20 cents)]. The other figures in column
6 are derived in the same way.
The result is that the MRP curve—the resource demand curve—of the imperfectly
competitive producer is less elastic than that of the purely competitive producer. At
a wage rate or MRC of $11.95, both the purely competitive and the imperfectly com-
petitive seller will hire two workers. But at $9.95 the competitive firm will hire three,
and the imperfectly competitive firm only two. At $7.95 the purely competitive firm
will employ four employees, and the imperfect competitor only three. You can see
this difference in resource demand elasticity when we graph the MRP data in Table
14-2 and compare the graph with Figure 14-1, as we do in Figure 14-2.1

FIGURE 14-2 THE IMPERFECTLY COMPETITIVE SELLER’S DEMAND

CURVE FOR A RESOURCE
An imperfectly P
competitive seller’s
resource demand $18
curve D (solid) slopes 16
Resource price (wage rate)

downward because
both marginal prod- 14
uct and product price
fall as resource 12
D = MRP
employment and out- 10 (pure competition)
put rise. This down-
ward slope is greater 8
than that for a purely
competitive seller 6
(dashed resource 4 D = MRP
demand curve) (imperfect
because the pure 2 competition)
competitor can sell
0
the added output at 1 2 3 4 5 6 7
a constant price. –2 Q
Quantity of resource demanded

1
Note that we plot the points in Figures 14-1 and 14-2 halfway between succeeding numbers of
resource units, because MRP is associated with the addition of one more unit. Thus, in Figure
14-2, for example, we plot the MRP of the second unit ($13.00) not at one or two, but rather at 1.5.
This smoothing enables us to sketch a continuously downsloping curve rather than one that
moves downward in discrete steps as each new unit of labour is hired.
 chapter fourteen • the demand for resources 359

It is not surprising that the imperfectly competitive producer is less responsive

to resource price cuts than the purely competitive producer. The imperfect com-
petitor’s relative reluctance to employ more resources, and produce more output,
when resource prices fall reflects the imperfect competitor’s tendency to restrict out-
put in the product market. Other things equal, the imperfectly competitive seller
produces less of a product than a purely competitive seller. In producing that
smaller output, it demands fewer resources.
But there is one important qualification. We noted in Chapter 11 that the market
structure of oligopoly might lead to technological progress and greater production,
more employment, and lower prices in the very long run than would a purely com-
petitive market. The resource demand curve in these cases would lie farther to the
right than it would if output were restricted as a result of monopoly power. (Key
Question 2)

Market Demand for a Resource

We have now explained the individual firm’s demand curve for a resource. Recall
that the total, or market, demand curve for a product is found by summing horizon-
tally the demand curves of all individual buyers in the market. The market demand
curve for a particular resource is derived in essentially the same way—by summing
the individual demand or MRP curves for all firms hiring that resource.

● To maximize profit a firm will use a resource in
an amount at which the resource’s marginal
revenue product equals its marginal resource
cost (MRP = MRC).
● Application of the MRP = MRC rule to a firm’s
MRP curve demonstrates that the MRP curve is
the firm’s resource demand curve. In a purely
competitive resource market, resource price
(the wage rate) equals MRC.
● The resource demand curve of a purely com-
petitive seller is downsloping solely because
the marginal product of the resource dimin-
ishes; the resource demand curve of an imper-
fectly competitive seller is downsloping because
marginal product diminishes and product price
falls as output is increased.

Determinants of Resource Demand

What will alter the demand for a resource—that is, shift the resource demand
curve? The fact that resource demand is derived from product demand and depends
on resource productivity suggests two things can shift resource demands. Also, our
analysis of how changes in the prices of other products can shift a product’s demand
curve (Chapter 3) suggests another factor: changes in the prices of other resources.

Changes in Product Demand

<www.theshortrun.com/
classroom/glossary/
Other things equal, an increase in the demand for a product that uses a particular resource
micro/resource.html> will increase the demand for the resource whereas a decrease in product demand will decrease
Resource demand the resource demand.
360 Part Three • Microeconomics of Resource Markets

Let’s see how this works. The first thing to recall is that a change in the demand
for a product will change its price. In Table 14-1, let’s assume that an increase in
product demand boosts the product price from $2 to $3. You should calculate the
new resource demand schedule (columns 1 and 6) that would result, and plot it in
Figure 14-1 to verify that the new resource demand curve lies to the right of the old
demand curve. Similarly, a decline in the product demand (and price) will shift the
resource demand curve to the left. This effect—resource demand changing along
with product demand—demonstrates that resource demand is derived from prod-
uct demand.

Changes in Productivity
Other things equal, an increase in the productivity of a resource will increase the demand
for the resource and a decrease in productivity will reduce the resource demand. If we
doubled the MP data of column 3 in Table 14-1, the MRP data of column 6 would
also double, indicating an increase (rightward shift) in the resource demand curve.
The productivity of any resource may be altered in several ways:
● Quantities of other resources The marginal productivity of any resource
will vary with the quantities of the other resources used with it. The greater the
amount of capital land resources used with, say, labour, the greater will be
labour’s marginal productivity and, thus, labour demand.
● Technological progress Technological improvements that increase the qual-
ity of other resources, such as capital, have the same effect. The better the qual-
ity of capital, the greater the productivity of labour used with it. Dockworkers
employed with a specific amount of real capital in the form of unloading
cranes are more productive than dockworkers with the same amount of real
capital embodied in older conveyer-belt systems.
● Quality of the variable resource Improvements in the quality of the variable
resource, such as labour, will increase its marginal productivity and therefore
its demand. In effect, there will be a new demand curve for a different, more
skilled, kind of labour.
All these considerations help explain why the average level of (real) wages is higher
in industrially advanced nations (for example, Canada, Germany, Japan, and
France) than in developing nations (for example, India, Ethiopia, Angola, and Cam-
bodia). Workers in industrially advanced nations are generally healthier, better edu-
cated, and better trained than are workers in developing countries. Also, in most
industries, workers in industrially advanced nations work with a larger and more
efficient stock of capital goods and more abundant natural resources. This creates a
strong demand for labour. On the supply side of the market, labour is relatively
scarce compared with that in most developing nations. A strong demand and a rel-
atively scarce supply of labour result in high wage rates in the industrially advanced
nations.

Changes in the Prices of Other Resources

Just as changes in the prices of other products will change the demand for a specific
product, changes in the prices of other resources will change the demand for a spe-
cific resource. Also recall that the effect of a change in the price or product X on the
demand for product Y depends on whether X and Y are substitute goods or
 chapter fourteen • the demand for resources 361

complementary goods in consumption. Similarly, the effect of a change in the price

of resource A on the demand for resource B depends on their substitutability or their
complementarity in production.

SUBSTITUTE RESOURCES
Suppose the technology in a certain production process is such that labour and cap-
ital are substitutable. A firm can produce some specific amount of output using a rel-
atively small amount of labour and a relatively large amount of capital, or vice
versa. Now assume that the price of machinery (capital) falls. The effect on the
demand for labour will be the net result of two opposed effects: the substitution
effect and the output effect.
● Substitution effect The decline in the price of machinery prompts the firm to
substitute machinery for labour. This substitution allows the firm to produce
its output at a lower cost. So, at the fixed wage rate, smaller quantities of
substitu- labour are now employed. This substitution effect decreases the demand for
tion effect labour. More generally, the substitution effect indicates that a firm will pur-
A firm will purchase chase more of an input whose relative price has declined and, conversely, use
more of an output
whose relative price
less of an output whose relative price has increased.
has declined and ● Output effect Because the price of machinery has fallen, the costs of produc-
use less of an input
whose relative price
ing various outputs must also decline. With lower costs, the firm finds it prof-
has increased. itable to produce and sell a greater output. The greater output increases the
demand for all resources, including labour. So, this output effect increases the
output demand for labour. More generally, the output effect means that the firm will
effect An purchase more of one particular input when the price of the other input falls
increase in the price
of one input will
and less of that particular input when the price of the other input rises.
increase a firm’s ● Net effect The substitution and output effects are both present when the price
production costs
and reduce its level
of an input changes, but they work in opposite directions. For a decline in the
of output, thus re- price of capital, the substitution effect decreases the demand for labour and the
ducing the demand output effect increases it. The net change in labour demand depends on the rel-
for other outputs ative sizes of the two effects.
(and vice versa).
In terms of resource demand, if the substitution effect outweighs the output effect,
a decrease in the price of capital decreases the demand for labour. If the output effect
exceeds the substitution effect, a decrease in the price of capital increases the
demand for labour.

COMPLEMENTARY RESOURCES
Recall from Chapter 3 that certain products, such as cameras and film or computers
and software, are complementary goods; they go together and are jointly
demanded. Resources may also be complementary; an increase in the quantity of
one of them used in the production process requires an increase in the amount used
of the other as well, and vice versa. Suppose a small design firm does computer-
assisted design (CAD) with relatively expensive personal computers as its basic
piece of capital equipment. Each computer requires a single design engineer to oper-
ate it; the machine is not automated—it will not run itself—and a second engineer
would have nothing to do.
Now assume that a technological advance in the production of these comput-
ers substantially reduces their price. No substitution effect can occur, because
362 Part Three • Microeconomics of Resource Markets

labour and capital must be used in fixed proportions, one person for one machine.
Capital cannot be substituted for labour. But there is an output effect. Other
things equal, the reduction in the price of capital goods means lower production
costs. It will, therefore, be profitable to produce a larger output. In doing so, the
firm will use both more capital and more labour. When labour and capital are
complementary, a decline in the price of capital increases the demand for labour through the
output effect.
We have cast our analysis of substitute resources and complementary resources
mainly in terms of a decline in the price of capital. In Table 14-3 we summarize
the effects of an increase in the price of capital on the demand for labour; study it
carefully.
Now that we have discussed the full list of the determinants of labour demand,
let’s again review their effects. Stated in terms of the labour resource, the demand
for labour will increase (the labour demand curve will shift rightward) when
● The demand for (and therefore the price of) the product produced by that
labour increases.
● The productivity (MP) of labour increases.
● The price of a substitute input decreases, provided the output effect exceeds the
substitution effect.
● The price of a substitute input increases, provided the substitution effect
exceeds the output effect.
● The price of a complementary input decreases.
Be sure that you can reverse these effects to explain a decrease in labour demand.
Table 14-4 provides several illustrations of the determinants of labour demand,
listed by the categories of determinants we have discussed; give them a close look.

TABLE 14-3 THE EFFECT OF AN INCREASE IN THE PRICE OF

CAPITAL ON THE DEMAND FOR LABOUR, DL
(1) (2)
Relationship Increase in the price of capital
of inputs
(a) (b) (c)
Substitution Output effect Combined effect
effect

Substitutes in Labour substituted Production costs up, DL increases if the

production for capital output down, and less substitution effect exceeds
of both capital and the output effect; DL
labour used decreases if the output
effect exceeds the
substitution effect
Complements No substitution Production costs up, DL decreases
in production of labour for capital output down, and less
of both capital and
labour used
 chapter fourteen • the demand for resources 363

TABLE 14-4 DETERMINANTS OF LABOUR DEMAND: FACTORS

THAT SHIFT THE LABOUR DEMAND CURVE
Determinant Examples

Changes in Gambling increases in popularity, increasing the demand for workers at casinos.
product Consumers decrease their demand for leather coats, decreasing the demand for tanners.
demand The federal government reduces spending on the military, reducing the demand for
military personnel.
Changes in An increase in the skill levels and output of glassblowers increases the demand for
productivity their services.
Computer-assisted graphic design increases the productivity of, and demand for,
graphic artists.
Changes in An increase in the price of electricity increases the cost of producing aluminum and
the price reduces the demand for aluminum workers.
of another The price of security equipment used by businesses to protect against illegal entry
resource falls, decreasing the demand for night guards.
The price of telephone switching equipment decreases, greatly reducing the cost of
telephone service, which in turn increases the demand for telemarketers.

Occupational Employment Trends

Changes in labour demand have considerable significance, since they affect wage
rates and employment in specific occupations. Increases in labour demand for certain
occupational groups result in increases in their employment, and decreases in labour
demand result in decreases in their employment. For illustration, let’s look at occu-
pations that are growing in demand. (Wage rates are the subject of the next chapter).

THE FASTEST GROWING OCCUPATIONS

The occupations that are growing quickly in the Canadian economy tend to be service
occupations. In general, the demand for service workers is rapidly outpacing the
demand for manufacturing, construction, and mining workers. The top five fastest
growing jobs are directly computer-related. The increase in the demand for computer
engineers, computer support specialists, systems analysts, database managers, and
desktop publishing specialists relates to the rapid rise in the demand for computers,
<www.adin.org/lmi/
computer services, and the Internet. It also relates to the rising productivity of these par-
fastest.htm>
Fastest growing and ticular workers, given the vastly improved quality of the computer and communica-
declining occupations, tions equipment they work with. Price declines on such equipment have had a stronger
Ontario, 1995–2005 output effect than substitution effect, increasing the demand for these types of labour.
Three of the other fastest growing occupations relate to health care: personal care
and home health care aides, medical assistants, and physician assistants. The grow-
ing demands for these types of labour are derived from the growing demand for
health services, caused by several factors. The aging of the Canadian population has
brought with it more medical problems, and the rising standard of income has led
to greater expenditures on health care.

Elasticity of Resource Demand

The employment changes we have just discussed result from shifts in the locations
of resource demand curves. Such changes in demand must be distinguished from
364 Part Three • Microeconomics of Resource Markets

changes in the quantity of a resource demanded caused by a change in the price

of the specific resource under consideration. Such a change is not caused by a shift
of the demand curve but rather by a movement from one point to another on a fixed
resource demand curve. For example, in Figure 14-1 we note that an increase in the
wage rate from $5 to $7 will reduce the quantity of labour demanded from five to
four units. This is a change in the quantity of labour demanded as distinct from a change
in demand.
The sensitivity of producers to changes in resource prices is measured by the
elasticity elasticity of resource demand. In coefficient form,
of resource
demand The percentage change in resource quantity
Erd = ᎏᎏᎏᎏᎏ
percentage change percentage change in resource price
in resource quantity
divided by the per- When Erd is greater than one, resource demand is elastic; when Erd is less than one,
centage change in resource demand is inelastic; and when Erd equals one, resource demand is unit-
resource price. elastic. (Recall from Chapter 6 that demand elasticity has a negative sign, but we use
the absolute value.) What determines the elasticity of resource demand? Several fac-
tors are at work.

RATE OF MP DECLINE
A purely technical consideration is the rate at which the marginal product of the
particular resource declines. If the marginal product of one resource declines slowly
as it is added to a fixed amount of other resources, the demand (MRP) curve for that
resource declines slowly and tends to be highly elastic. A small decline in the price
of such a resource will yield a relatively large increase in the amount demanded.
Conversely, if the marginal product of the resource declines sharply as more of it is
added, the resource demand curve also declines rapidly. This means that a relatively
large decline in the wage rate will be accompanied by a modest increase in the
amount of labour hired; labour demand is inelastic.

EASE OF RESOURCE SUBSTITUTABILITY

The degree to which resources are substitutable is also a determinant of elasticity. The
larger the number of satisfactory substitute resources available, the greater the elasticity of
demand for a particular resource. If a furniture manufacturer finds that five or six dif-
ferent types of wood are equally satisfactory in making coffee tables, a rise in the
price of any one type of wood may cause a sharp drop in the amount demanded as
the producer substitutes one of other woods. At the other extreme, no reasonable
substitutes may exist; bauxite is absolutely essential in the production of aluminum
ingots. Thus, the demand for bauxite by aluminum producers is inelastic.
Time can play a role in the input substitution process. For example, a firm’s truck
drivers may obtain a substantial wage increase with little or no immediate decline
in employment. But over time, as the firm’s trucks wear out and are replaced, that
wage increase may motivate the company to purchase larger trucks and in that
way deliver the same total output with fewer drivers. Another example is the new
commercial aircraft that require only two cockpit personnel rather than the former
three, again indicating some substitutability between labour and capital if there is
enough time.

ELASTICITY OF PRODUCT DEMAND

The elasticity of demand for any resource depends on the elasticity of demand for
the product it helps produce. The greater the elasticity of product demand, the greater
 chapter fourteen • the demand for resources 365

the elasticity of resource demand. The derived nature of resource demand leads us
to expect this relationship. A small rise in the price of a product with great elas-
ticity of demand will sharply reduce output, bringing about relatively large de-
clines in the amounts of various resources demanded; the demand for the resource
is elastic.
Remember that the resource demand curve of Figure 14-1 is more elastic than the
resource demand curve shown in Figure 14-2. The difference arises because in Fig-
ure 14-1, we assume a perfectly elastic product demand curve, while Figure 14-2 is
based on a downsloping or less than perfectly elastic product demand curve.

RATIO OF RESOURCE COST TO TOTAL COST

The larger the proportion of total production costs accounted for by a resource, the greater
the elasticity of demand for that resource. In the extreme, if labour cost is the only pro-
duction cost, then a 20 percent increase in wage rates will shift all the firm’s cost
curves upward by 20 percent. If product demand is elastic, this substantial increase
in costs will cause a relatively large decline in sales and a sharp decline in the
amount of labour demanded. So labour demand is highly elastic. But if labour cost
is only 50 percent of production cost, then a 20 percent increase in wage rates
will increase costs by only 10 percent. With the same elasticity of product demand,
this will cause a relatively small decline in sales and, therefore, in the amount
of labour demanded. In this case the demand for labour is much less elastic. (Key
Question 3)

● A resource demand curve will shift because of
changes in product demand, changes in the
productivity of the resource, and changes in
the prices of other inputs.
● If resources A and B are substitutable, a decline
in the price of A will decrease the demand for
B provided the substitution effect exceeds the
output effect. If the output effect exceeds the
substitution effect, the demand for B will
increase.
● If resources C and D are complements, a decline
in the price of C will increase the demand for D.
● Elasticity of resource demand measures the
extent to which producers change the quantity
of a resource they hire when its price changes.
● The elasticity of resource demand will be less
the more rapid the decline in marginal product,
the smaller the number of substitutes, the
smaller the elasticity of product demand, and
the smaller the proportion of total cost ac-
counted for by the resource.

Optimal Combination of Resources

Choosing
So far our main focus has been on one variable input, labour. But in the long run,
a Little More firms can vary the amounts of all the resources they use. That’s why we need to con-
or Less
sider what combination of resources a firm will choose when all its inputs are vari-
able. While our analysis is based on two resources, it can be extended to any
number of inputs.
We will consider two interrelated questions:
1. What combination of resources will minimize costs at a specific level of output?
2. What combination of resources will maximize profit?
366 Part Three • Microeconomics of Resource Markets

The Least-Cost Rule

least- A firm is producing a specific output with the least-cost combination of resources
cost combi- when the last dollar spent on each resource yields the same marginal product. That is, the
nation of cost of any output is minimized when the ratios of marginal product to price of the
resources
The quantity of last units of resources used are the same for each resource. In competitive resource
each resource a markets marginal resource cost is the market resource price; the firm can hire as
firm must employ to many or as few units of the resources as it wants at that price. Then, with just two
produce a particular resources, labour and capital, a competitive firm minimizes its total cost of a specific
output at the lowest output when
total cost.
Marginal Product of Labour (MPL) Marginal Product of Capital (MPc)
ᎏᎏᎏᎏ = ᎏᎏᎏᎏ (1)
Price of Labour (PL) Price of Capital (Pc)

Throughout, we will refer to the marginal products of labour and capital as MPL and
MPC , respectively, and symbolize the price of labour by PL and the price of capital
by PC.
A concrete example shows why fulfilling the condition in equation (1) leads to
least-cost production. Assume that the price of both capital and labour is $1 per unit,
but that they are currently employed in such amounts that the marginal product of
labour is 10 and the marginal product of capital is 5. Our equation immediately tells
us that this is not the least costly combination of resources:

MPL × 10 MPC × 5
ᎏᎏ >ᎏ
PL × $1 PC × $1

Suppose the firm spends $1 less on capital and shifts that dollar to labour. It loses
five units of output produced by the last dollar’s worth of capital, but it gains 10
units of output from the extra dollar’s worth of labour. Net output increases by 5
(= 10 – 5) units for the same total cost. More such shifting of dollars from capital to
labour will push the firm down along its MP curve for labour and up along its MP
curve for capital, increasing output and moving the firm toward a position of equi-
librium where equation (1) is fulfilled. At that equilibrium position, the MP per dol-
lar for the last unit of both labour and capital might be, for example, seven. The firm
will be producing a greater output for the same (original) cost.
Whenever the same total resource cost can result in a greater total output, the cost
per unit—and therefore the total cost of any specific level of output—can be
reduced. Being able to produce a larger output with a specific total cost is the same
as being able to produce a specific output with a smaller total cost. If the firm in our
example buys $1 less of capital, its output will fall by five units. If it spends only $.50
of that dollar on labour, the firm will increase its output by a compensating five
units (= 1⁄2 of the MP per dollar). Then the firm will realize the same total output at
a $.50 lower total cost.
The cost of producing any specific output can be reduced as long as equation (1)
does not hold. But when dollars have been shifted between capital and labour to the
point where equation (1) holds, no additional changes in the use of capital and
labour will reduce costs further. The firm is now producing that output using the
least-cost combination of capital and labour.
All the long-run cost curves developed in Chapter 8 and used thereafter assume that the
least-cost combination of inputs has been realized at each level of output. Any firm that com-
bines resources in violation of the least-cost rule would have a higher-than-necessary
average total cost at each level of output; that is, it would incur X-inefficiency, as dis-
cussed in Figure 10-7.
 chapter fourteen • the demand for resources 367

The producer’s least-cost rule is analogous to the consumer’s utility-maximizing

rule described in Chapter 7. In achieving the utility-maximizing combination of
goods, consumers consider both their preferences, as reflected in diminishing-
marginal-utility data, and the prices of the various products. Similarly, in achieving
the cost-minimizing combination of resources, producers consider both the mar-
ginal product data and the price (costs) of the various resources.

The Profit-Maximizing Rule

Minimizing cost is not sufficient for maximizing profit. A firm can produce any level
of output in the least costly way by applying equation (1), but only one unique
level of output can maximize profit. Our earlier analysis of product markets showed
that this profit-maximizing output occurs where marginal revenue equals marginal
cost (MR = MC). Near the beginning of this chapter, we determined that we could
write this profit-maximizing condition as MRP = MRC as it relates to resource
inputs.
In a purely competitive resource market, the marginal resource cost (MRC) is
exactly equal to the resource price, P. Thus, for any competitive resource market, we
have as our profit-maximizing equation
MRP (resource) = P (resource)
This condition must hold for every variable resource and in the long run all
resources are variable. In competitive markets, a firm will, therefore, achieve its
profit- profit-maximizing combination of resources when each resource is employed to
maximizing the point at which its marginal revenue product equals its price. For two resources,
combina- labour and capital, we need both PL = MRPL and PC = MRPC
tion of We can combine these conditions by dividing both sides of each equation by their
resources
The quantity of respective prices and equating the results, to get
each resource a
MRP MRPC
firm must employ ᎏL = ᎏ =1 (2)
to maximize its PL PC
profits or minimize
its losses. Note in equation (2) that it is not sufficient that the MRPs of the two resources be
proportionate to their prices; the MRPs must be equal to their prices and the ratios,
therefore, equal to one. For example, if MRPL = $15, PL = $5, MRPC = $9, and PC = $3,
the firm is underemploying both capital and labour even though the ratios of MRP
to resource price are identical for both resources. The firm can expand its profit by
hiring additional amounts of both capital and labour until it moves down their
downsloping MRP curves to the points at which MRPL = $5 and MRPC = $3. The
ratios will then be 5/5 and 3/3 and equal to one.
The profit-maximizing position in equation (2) includes the cost-minimizing con-
dition of equation (1). That is, if a firm is minimizing profit according to equation
(2), then it must be using the least-cost combination of inputs to do so. However, the
converse is not true: a firm operating at least cost according to equation (1) may not
be operating at the output that maximizes its profit.

Numerical Illustration
A numerical illustration will help you understand the least-cost and profit-
maximizing rules. In columns 2, 3, 2⬘, and 3⬘ in Table 14-5, we show the total prod-
ucts and marginal products for various amounts of labour and capital that are
assumed to be the only inputs needed in producing some product, say, key chains.
Both inputs are subject to diminishing returns.
368 Part Three • Microeconomics of Resource Markets

TABLE 14-5 DATA FOR FINDING THE LEAST-COST AND

PROFIT-MAXIMIZING COMBINATION OF
LABOUR AND CAPITAL*
LABOUR (PRICE = $8) CAPITAL (PRICE = $12)
(1) (2) (3) (4) (5) (1) (2) (3) (4) (5)
Quantity Total Marginal Total Marginal Quantity Total Marginal Total Marginal
product product revenue revenue product product revenue revenue
(output) product (output) product

0 0 $ 0 0 0 $ 0
12 $24 13 $26
1 12 24 1 13 26
10 20 9 18
2 22 44 2 22 44
6 12 6 12
3 28 56 3 28 56
5 10 4 8
4 33 66 4 32 64
4 8 3 6
5 37 74 5 35 70
3 6 2 4
6 40 80 6 37 74
2 4 1 2
7 42 84 7 38 76
*To simplify, it is assumed in this table that the productivity of each resource is independent of the quantity of the other. For
example, the total and marginal product of labour is assumed not to vary with the quantity of capital employed.

We also assume that labour and capital are supplied in competitive resource mar-
kets at $8 and $12, respectively, and that key chains sell competitively at $2 per unit.
For both labour and capital, we can determine the total revenue associated with
each input level by multiplying total product by the $2 product price. These data are
shown in columns 4 and 4⬘. They enable us to calculate the marginal revenue prod-
uct of each successive input of labour and capital as shown in columns 5 and 5⬘,
respectively.

PRODUCING AT LEAST COST

What it the least-cost combination of labour and capital to use in producing, say, 50
units of output? The answer, which we can obtain by trial and error, is three units
of labour and two units of capital. Columns 2 and 2⬘ indicate that this combination
of labour and capital does, indeed, result in the required 50 (= 28 + 22) units of out-
put. Now, note from columns 3 and 3⬘ that hiring three units of labour gives us
MPL /PL = 6⁄8 = 3⁄4, and hiring two units of capital gives us MPC /PC = 9⁄12 = 3⁄4. So, equa-
tion (1) is fulfilled. How can we verify that costs are actually minimized? First, we
see that the total cost of employing three units of labour and two of capital is $48
[= (3 × $8) + (2 × $12)].
Other combinations of labour and capital will also yield 50 units of output but at
a higher cost than $48. For example, five units of labour and one unit of capital will
produce 50 (= 37 + 13) units, but total cost is higher at $52 [= (5 × $8) + (1 × $12)].
This result comes as no surprise, because five units of labour and one unit of capi-
tal violate the least-cost rule—MPL /PL = 4⁄8, MPC /PC = 13⁄12. Only the combination
(three units of labour and two units of capital) that minimizes total cost will satisfy
equation (1). All other combinations capable of producing 50 units of output violate
the cost-minimizing rule, and, therefore, cost more than $48.
 chapter fourteen • the demand for resources 369

MAXIMIZING PROFIT
Will 50 units of output maximize the firm’s profit? No, because the profit-maximizing
terms of equation (2) are not satisfied when the firm employs three units of labour
and two of capital. To maximize profit, each input should be employed until its price
equals its marginal revenue product. But for three units of labour, labour’s MRP in
column 5 is $12 while its price is only $8; the firm could increase its profit by hiring
more labour. Similarly, for two units of capital, we see in column 5⬘ that capital’s
MRP is $18 and its price is only $12. This result indicates that more capital should
also be employed. By producing only 50 units of output (even though they are pro-
duced at least cost), labour and capital are being used in less-than-profit-maximizing
amounts. The firm needs to expand its employment of labour and capital, thereby
increasing its output.
Table 14-5 shows that the MRPs of labour and capital are equal to their prices, so
that equation (2) is fulfilled when the firm is employing five units of labour and three
units of capital. This is the profit-maximizing combination of inputs.2 The firm’s total
cost will be $76, made up of $40 (= 5 × $8) of labour and $36 (= 3 × $12) of capital. Total
revenue will be $130, found either by multiplying the total output of 65 (= 37 + 28)
by the $2 product price or by summing the total revenues attributable to labour ($74)
and to capital ($56). The difference between total revenue and total cost in this
instance is $54 (= $130 – $76). Experiment with other combinations of labour and cap-
ital to demonstrate that they yield an economic profit of less than $54.
Note that the profit-maximizing combination of five units of labour and three
units of capital is also a least-cost combination for this particular level of output.
Using these resource amounts satisfies the least-cost requirement of equation (1) in
that MPL /PL = 4⁄8 = 1⁄2 and MPC /PC = 6⁄12 = 1⁄2. (Key Questions 4 and 5)

Marginal Productivity Theory

of Income Distribution
Our discussion of resource pricing is the cornerstone of the controversial view that
marginal
productiv- fairness and economic justice are two of the outcomes of a competitive capitalist
ity theory economy. Table 14-5 tells us, in effect, that workers receive income payments (wages)
of income equal to the marginal contributions they make to their employers’ outputs and rev-
distribution enues. In other words, workers are paid according to the value of the labour services
The contention that that they contribute to production. Similarly, owners of the other resources receive
the distribution of
income is fair when income based on the value of the resources they supply in the production process.
each unit of each In this marginal productivity theory of income distribution, income is distrib-
resource receives a uted according to the contribution to society’s output. So, if you are willing to accept
money payment the ethical proposition “To each according to what he or she creates,” income pay-
equal to its mar- ments based on marginal revenue product seem to provide a fair and equitable dis-
ginal contribution
to the firm’s rev- tribution of society’s income.
enue (its marginal This idea sounds fair enough, but there are serious criticisms of this theory of
revenue product). income distribution;

2
Because we are dealing with discrete (nonfractional) units of the two outputs here, the use of
four units of labour and two units of capital is equally profitable. The fifth unit of labour’s MRP
and its price (cost) are equal at $8, so that the fifth labour unit neither adds to nor subtracts from
the firm’s profit; similarly, the third unit of capital has no effect on profit.
370 Part Three • Microeconomics of Resource Markets

● Inequality Critics argue that the distribution of income resulting from pay-
ment according to marginal productivity may be highly unequal because pro-
ductive resources are very unequally distributed in the first place. Aside from
their differences in mental and physical attributes, individuals encounter sub-
stantially different opportunities to enhance their productivity through edu-
cation and training. Some people may not be able to participate in production
at all because of mental or physical disabilities, and they would obtain no
income under a system of distribution based solely on marginal productivity.
Ownership of property resources is also highly unequal. Many landlords and
capitalists obtain their property by inheritance rather than through their own
productive effort. Hence, income from inherited property resources conflicts
with the “To each according to what he or she creates” idea. This reasoning
calls for government policies that modify the income distributions made
strictly according to marginal productivity.
● Market Imperfections The marginal productivity theory rests on the assump-
tions of competitive markets. Yet labour markets, for example, are riddled with
imperfections, as you will see in Chapter 15. Some employers exert pricing
power in hiring workers. And some workers, through labour unions, profes-
sional associations, and occupational licensing laws, wield monopoly power
in selling their services. Even the process of collective bargaining over wages
suggests a power struggle over the division of income. In this struggle, mar-
ket forces—and income shares based on marginal productivity—may get
pushed into the background. In addition, discrimination in the labour market
can distort earnings patterns. In short, because of real-world market imper-
fections, wage rates and other resource prices frequently are not based solely
on contributions to output.

As you have learned from this
chapter, a firm achieves its least-
cost combination of inputs when
the last dollar it spends on each
input makes the same contribu-
tion to total output. This raises an
interesting real-world question:
What happens when technologi-
cal advance makes available a
new, highly productive capital
good for which MP/P is greater
than it is for other inputs, say a
particular type of labour? The an-
swer is that the least-cost mix of
INPUT SUBSTITUTION:
THE CASE OF ATMS
Banks are using more automatic teller machines (ATMs)
and employing fewer human tellers.
resources abruptly changes and
the firm responds accordingly. If
the new capital is a substitute
for labour (rather than a comple-
ment), the firm replaces the par-
ticular type of labour with the
new capital. That is exactly what
is happening in the banking in-
dustry, in which ATMs are replac-
ing human bank tellers.
ATMs made their debut about
30 years age when Diebold, a
U.S. firm, introduced the prod-
uct. Today, Diebold and NCR
(also a U.S. firm) dominate
global sales, with the Japanese
firm Fujitsu a distant third. The
number of ATMs and their usage
have exploded, and currently
 chapter fourteen • the demand for resources 371

more than 26,000 ATMs are used
in Canada. We rank number one
in the world in ATM use, logging
53 transactions per Canadian
in 1997, followed by the United
State at 41.4 and Sweden at 37.6.
There are now 709,000 ATMs
worldwide.
ATMs are highly productive:
A single machine can handle
hundreds of transactions daily,
thousands weekly, and millions
over the course of several years.
ATMs can not only handle cash
withdrawals, but they can also
accept deposits and facilitate
switches of funds between vari-
ous accounts. Although ATMs
are expensive for banks to buy
and install, they are available
24 hours a day, and their cost
per transaction is one-fourth the
cost for human tellers. They
rarely get held up, and they do
not quit their jobs (turnover
among human tellers is nearly
50 percent per year). ATMs are
highly convenient; unlike human
tellers, they are located not only
at banks but also at busy street
corners, workplaces, universi-
ties, and shopping malls. The
same bankcard that enables you
to withdraw cash from your local
ATM also enables you to with-
draw pounds from an ATM in
London, yen from an ATM
in Tokyo, and even rubles from
an ATM in Moscow. (All this,
of course, assumes that you
have money in your account.)
In the terminology of this
chapter, the more productive,
lower-priced ATMs have reduced
the demand for a substitute in
production—human tellers. Be-
tween 1990 and 2000, 6000
human teller positions were
eliminated, and half the remain-
ing teller positions may be gone
by 2010. Where will the people
holding these jobs go? Most will
eventually move to other occu-
pations. Although the lives of
individual tellers are disrupted,
society clearly wins. Society
gets cheaper, more convenient
banking services and more of
the other goods that these freed-
up labour resources help to
produce.
Source: Based partly on Ben Craig,
“Where Have All the Tellers Gone?”
Economic Commentary (Federal
Reserve Bank of Cleveland), April.
15, 1997; and statistics provided by
the Canadian Bankers Association.

chapter summary
1. Resource prices act as a determinant of money
incomes, and they simultaneously ration
resources to various industries and firms.
2. The demand for any resource is derived
from the product it helps produce. That
means the demand for a resource will
depend on its productivity and on the market
value (price) of the good it is producing.
3. Marginal revenue product is the extra rev-
enue a firm obtains when it employs one
more unit of a resource. The marginal-
revenue-product curve for any resource is the
demand curve for that resource, because the
firm equates resource price and MRP in deter-
mining its profit-maximizing level of resource
employment. Thus, each point on the MRP
curve indicates how many resource units the
firm will hire at a specific resource price.
4. The firm’s demand curve for a resource
slopes downward, because the marginal
product of additional units declines in accor-
dance with the law of diminishing returns.
When a firm is selling in an imperfectly
competitive market, the resource demand
curve falls for a second reason: Product price
must be reduced for the firm to sell a larger
output. We can derive the market demand
curve for a resource by summing horizon-
tally the demand curves of all the firms hir-
ing that resource.
5. The demand curve for a resource will shift as
the result of (a) a change in the demand for,
and therefore the price of, the product the
resource is producing; (b) changes in the
productivity of the resource; and (c) changes
in the prices of other resources.
372 Part Three • Microeconomics of Resource Markets

6. If resources A and B are substitutable for
each other, a decline in the price of A will
decrease the demand for B provided the sub-
stitution effect is greater than the output
effect. But if the output effect exceeds the
substitution effect, a decline in the price of A
will increase the demand for B.
7. If resources C and D are complementary or
jointly demanded, there is only an output
effect; a change in the price of C will change
the demand for D in the opposite direction.
8. The majority of the fastest growing occupa-
tions in Canada relate to computers or health
care.
9. The elasticity of demand for a resource
measures the responsiveness of producers to
a change in the resource’s price. The coeffi-
cient of the elasticity of resource demand is
percentage change in resource quantity
Erd ᎏᎏᎏᎏᎏ
percentage change in resource price
When Erd is greater than one, resource de-
mand is elastic; when Erd is less than one,
resource demand is inelastic; and when Erd
equals one, resource demand is unit elastic.
10. The elasticity of demand for a resource will
be greater (a) the more slowly the marginal
product of the resource declines, (b) the
larger the number of good substitute
resources available, (c) the greater the elas-
ticity of demand for the product, and (d) the
larger the proportion of total production
costs attributable to the resource.
11. Any specific level of output will be produced
with the least costly combination of variable
resources when the marginal product per
dollar’s worth of each input is the same—
that is, when
MP of Labour MP of Capital
ᎏᎏ = ᎏᎏ
Price of Labour Price of Capital
12. A firm is employing the profit-maximizing
combination of resources when each re-
source is used to the point where its mar-
ginal revenue product equals its price. In
terms of labour and capital, that occurs
when the MRP of labour equals the price of
labour and the MRP of capital equals the
price of capital—that is, when
MRP of Labour MRP of Capital
ᎏᎏ = ᎏᎏ = 1
Price of Labour Price of Capital
13. The marginal productivity theory of income
distribution holds that all resources are paid
what they are economically worth: their mar-
ginal contribution to output. Critics assert
that such an income distribution is too
unequal and the real-world market imperfec-
tions result in pay above and below mar-
ginal contributions to output.

terms and concepts

derived demand, p. 353
marginal product (MP), p. 355
marginal revenue product
(MRP), p. 355
marginal resource cost
(MRC), p. 356
MRP = MRC rule, p. 356
substitution effect, p. 361
output effect, p. 361
elasticity of resource demand,
p. 364
least-cost combination of
resources, p. 366
profit-maximizing
combination of resources,
p. 367
marginal productivity theory
of income distribution,
p. 369

study questions
1. What is the significance of resource pricing?
Explain how the factors determining resource
demand differ from those underlying product
demand. Explain the meaning and signifi-
cance of the fact that the demand for a re-
source is a derived demand. Why do resource
demand curves slope downward?
2. KEY QUESTION Complete the follow-
ing labour demand table for a firm that is hir-
ing labour competitively and selling its prod-
uct in a competitive market.
a. How many workers will the firm hire if
the market wage rate is $27.95? $19.95?
Explain why the firm will not hire a larger
or smaller number of units of labour at
each of these wage rates.
b. Show in schedule form and graphically the
labour demand curve of this firm.
 chapter fourteen • the demand for resources 373

c. Now redetermine the firm’s demand curve Units of MP of Units of MP of

for labour, assuming that it is selling in an capital capital labour labour
imperfectly competitive market and that,
although it can sell 17 units at $2.20 per 0 0
24 11
unit, it must lower product price by 5 cents 1 1
21 9
to sell the marginal product of each suc- 2 2
cessive labour unit. Compare this demand 18 8
3 3
curve with that derived in question 2b. 15 7
Which curve is more elastic? Explain. 4 4
9 6
5 5
6 4
Units Marginal 6 6
of Total Marginal Product Total revenue 3 1
labour product product price revenue product 7 7
1 1
⁄2
8 8
0 0 $2 $_____
_____ $_____ a. What is the least-cost combination of
1 17 2 _____ labour and capital the firm should employ
_____ _____
2 31 2 _____ in producing 80 units of output? Explain.
_____ _____
3 43 2 _____ b. What is the profit-maximizing combination
_____ _____
4 53 2 _____ of labour and capital the firm should use?
_____ _____ Explain. What is the resulting level of out-
5 60 2 _____
_____ _____ put? What is the economic profit? Is this
6 65 2 _____ the least costly way of producing the
profit-maximizing output?
3. KEY QUESTION What factors deter- 5. KEY QUESTION In each of the follow-
mine the elasticity of resource demand? What ing four cases, MRPL and MRPC refer to the
effect will each of the following have on the marginal revenue products of labour and capi-
elasticity or the location of the demand for tal, respectively, and PL and PC refer to their
resource C, which is being used to produce prices. Indicate in each case whether the condi-
commodity X? Where there is any uncertainty tions are consistent with maximum profits for
as to the outcome, specify the causes of that the firm. If not, state which resource(s) should
uncertainty. be used in larger amounts and which re-
a. An increase in the demand for product X source(s) should be used in smaller amounts.
a. MRPL = $8; PL = $4; MRPC = $8; PC = $4
b. An increase in the price of substitute re-
source D b. MRPL = $10; PL = $12; MRPC = $14; PC = $9
c. MRPL = $6; PL = $6; MRPC = $12; PC = $12
c. An increase in the number of resources
substitutable for C in producing X d. MRPL = $22; PL = $26; MRPC = $16; PC = $19
6. Florida citrus growers say that the recent
d. A technological improvement in the capi- crackdown on illegal immigration is increasing
tal equipment with which resource C is the market wage rates necessary to get their
combined oranges picked. Some are turning to $100,000
e. A decline in the price of complementary to $300,000 mechanical harvesters known
resource E as “trunk, shake, and catch” pickers, which
vigourously shake oranges from the trees. If
f. A decline in the elasticity of demand for widely adopted, what will be the effect on the
product X due to a decline in the competi- demand for human orange pickers? What does
tiveness of the product market that imply about the relative strengths of the
4. KEY QUESTION Suppose the produc- substitution and output effects?
tivity of capital and labour are as shown in 7. (The Last Word) Explain the economics of the
the accompanying table. The output of these substitution of ATMs for human tellers. Some
resources sells in a purely competitive market banks are beginning to assess transaction
for $1 per unit. Both capital and labour are fees when customers use human tellers rather
hired under purely competitive conditions at than ATMs. What are these banks trying to
$3 and $1, respectively. accomplish?
374 Part Three • Microeconomics of Resource Markets
internet application questions
1. Go to Human Resource and Development
Canada at <www11.hrdc-drhc.gc.ca/jf-ea/
jf.prospects_by_current1?p_rating=1> to de-
termine the specific employment outlooks for
several occupations. For which job are
prospects good now but only fair in 2004?
2. Increases in employment reflect increases in
labour demand, accompanied by increases in
labour supply. Go the Bureau of Labour Sta-
tistics at <stat.bls.gov/top20.html> and select
International Labour Statistics (at the bottom).
Find the percentage increases in employment
for the United States, Japan, Germany, France,
Great Britain, Italy, and Canada for the most
recent 10-year period. Which three countries
have had the fastest growth of labour demand,
as measured by the employment outcome?
which three the slowest?
 FIFTEEN

Wage
Determination,
Discrimination,
and
Immigration
IN THIS CHAPTER
Y OU WILL LEARN:

N
early 15 million of us go to work each
That wages are determined
by demand and supply forces. day in Canada. We work at an amazing
•
variety of jobs for thousands of differ-
About the effects of
monopoly power on the ent firms for considerable differences in pay.
demand and supply of labour.
• What determines our hourly wage or annual
The pros and cons of
a minimum wage. salary? Why is the salary for, say, a top major
•
The effects of labour league baseball player $18 million a year,
market discrimination.
• whereas the pay for a first-rate schoolteacher
The effects of immigration on
is $60,000? Why are starting salaries for uni-
domestic labour markets.
versity graduates who major in engineering

and accounting so much higher than for grad-

uates majoring in journalism and sociology?

 376 Part Three • Microeconomics of Resource Markets

Having explored the major factors that underlie labour demand, we now bring
labour supply into our analysis to help answer these questions. Generally, labour sup-
ply and labour demand interact to determine the hourly wage rate or annual salary
in each occupation. Collectively, those wages and salaries make up about 70 percent
of the national income.

Labour, Wages, and Earnings

nominal Economists use the term “labour” broadly to apply to (1) blue-collar and white-col-
wage The lar workers of all varieties; (2) professional people such as lawyers, physicians, den-
amount of money tists, and teachers; and (3) owners of small businesses, including barbers, plumbers,
received by a
worker per unit
television repairers, and a host of retailers who provide labour as they carry on their
of time (hour, own businesses.
day, etc.). Wages are the price that employers pay for labour. Wages may take the form of
salaries, bonuses, royalties, or commissions. We will use the term “wages” to mean
real wage the wage rate per hour, per day, and so forth. That usage will remind us that a wage
The amount of
goods and services
rate is a price paid per unit of labour services. It will also let us distinguish between
a worker can pur- the wage rate and labour earnings, the latter being determined by multiplying the
chase with a nomi- number of hours worked per week, per month, or per year by the hourly wage or
nal wage. wage rate.
We must also distinguish between nominal wages and real wages. A nominal
wage is the amount of money received per hour, per day, and so on. A real wage is
the quantity of goods and services a worker can obtain with nominal wages; real
wages reveal the purchasing power of nominal wages.
Your real wage depends on your nominal wage and the prices of the goods and
services you purchase. Suppose you receive an 8 percent increase in your nominal
<www.internationalecon. wage during a certain year, but in that same year the price level increases by 5 per-
com/v1.0/ch40/
40c200.html>
cent. Then your real wage has increased by 3 percent (= 8 percent minus 5 percent).
The real wage Unless otherwise indicated, we will assume that the overall level of prices remains
effects of free trade constant. In other words, we will discuss only real wages.

General Level of Wages

Wages differ among nations, regions, occupations, and individuals. Wage rates are
much higher in Canada than in China or India. Wages are slightly higher in the
south and west of Canada than in the north. Plumbers are paid less than NHL
hockey players, and lawyer Adam may earn twice as much as lawyer Bharti for the
same number of hours of work. Wage rates also differ by gender, race, and ethnic
background.
The general, or average, level of wages, like the general level of prices, includes
a wide range of different wage rates. It includes the wages of bakers, barbers, brick
masons, and brain surgeons. By averaging such wages, we can more easily compare
wages among regions and among nations.
As Global Perspective 15.1 suggests, the general level of real wages in Canada is
relatively high—although not the highest in the world.
The simplest explanation for the high real wages in Canada and other industri-
ally advanced economies (referred to hereafter as advanced economies) is that
the demand for labour in these nations is relatively large compared to the supply
of labour.
chapter fifteen • wage determination, discrimination, and immigration 377

15.1

Hourly Pay in U.S. Dollars, 1999

Hourly wages of
0 4 8 12 16 20 24 28 32
production workers,
Germany
selected nations
Switzerland
Wage differences are pro- Denmark
nounced worldwide. The Sweden
data shown here indicate
Japan
that hourly compensation in United States
Canada is not as high as in
France
some European nations. It is
Italy
important to note, however,
United Kingdom
that the prices of goods and
Australia
services vary greatly among
Canada
nations, and the process of
Korea
converting foreign wages into
Taiwan
dollars may not accurately
Mexico
reflect such variations.
Source: U.S. Bureau of Labor Statistics, <stat.bls.gov>, 2000.

The Role of Productivity

We know from the previous chapter that the demand for labour, or for any other
resource, depends on its productivity. Generally, the greater the productivity of
labour, the greater the demand for it. If the total supply of labour is fixed, then the
stronger the demand for labour, the higher the average level of real wages. The
demand for labour in Canada and the other major advanced economies is large
because labour in these countries is highly productive. There are several reasons for
that high productivity:
● Plentiful capital Workers in the advanced economies have access to large
amounts of physical capital equipment (machinery and buildings). The total
physical capital per worker in Canada is one of the highest in the world.
● Access to abundant natural resources In advanced economies, natural re-
sources tend to be abundant in relation to the size of the labour force. Some of
those resources are available domestically and others are imported from
abroad. Canada, for example, is richly endowed with arable land, mineral
resources, and sources of energy for industry.
● Advanced technology The level of technological progress is generally high in
advanced economies. Not only do workers in these economies have more cap-
ital equipment to work with but that equipment is also technologically supe-
rior to the equipment available to the vast majority of workers worldwide.
Work methods in the advanced economies are steadily being improved
through scientific study and research.
378 Part Three • Microeconomics of Resource Markets

● Labour quality The health, vigour, education, and training of workers in

advanced economies are generally superior to those in developing nations,
which means that, even with the same quantity and quality of natural and cap-
ital resources, workers in advanced economies tend to be more efficient than
many of their foreign counterparts.
● Intangible factors Less tangible factors also may underlie the high produc-
tivity in some of the advanced economies. In Canada, for example, such fac-
tors include (1) the efficiency and flexibility of management; (2) business,
social, and political environments that emphasize production and productiv-
ity; and (3) the vast size of the domestic market, which enables firms to engage
in mass production.

Real Wages and Productivity

Figure 15-1 shows the close long-run relationship between output per hour of work
and real hourly earnings in Canada. Because real income and real output are two
ways of viewing the same thing, real income (earnings) per worker can increase
only at about the same rate as output per worker. When workers produce more
real output per hour, more real income is available to distribute to them for each
hour worked.
In the real world, however, suppliers of land, capital, and entrepreneurial talent
also share in the income from production. Real wages, therefore, do not always rise
in lockstep with gains in productivity over short spans of time. But over long peri-
ods, productivity and real wages tend to rise together.

FIGURE 15-1 OUTPUT PER HOUR AND REAL HOURLY EARNINGS

IN CANADA
Over the years a 150
close relationship
exists between
output per hour of Real compensation
work and real hourly 120 per person-hour
earnings.
Index (1992 = 100)

100
90

60 Output per person-hour

30

0
1974 1980 1985 1990 1995 1998
Source: Statistics Canada.
 chapter fifteen • wage determination, discrimination, and immigration 379

Secular Growth of Real Wages

Basic supply and demand analysis helps explain the long-term trend of real-wage
growth in Canada. The nation’s labour force has grown significantly over the
decades, but, as a result of the productivity-increasing factors we have mentioned,
labour demand has increased more rapidly than labour supply. Figure 15-2 shows
several such increases in labour supply and labour demand. The result has been a
long-run, or secular, increase in wage rates and employment.

A Purely Competitive Labour Market

Choosing
We now turn from the average level of wages to specific wage rates. What deter-
a Little More mines the wage rate paid for some specific type of labour? Demand and supply
or Less
analysis is again revealing. Let’s begin by examining labour demand and labour
supply in a purely competitive labour market. In this type of market
purely ● Many firms compete with one another in hiring a specific type of labour.
competitive
labour ● Each of numerous qualified workers with identical skills supplies that type of
market A labour.
resource market in
which a large num- ● Individual firms and individual workers are wage-takers, since neither can
ber of (noncollud- exert any control over the market wage rate.
ing) firms demand
a particular type of
labour supplied by Market Demand for Labour
a large number of Suppose 200 firms demand a particular type of labour, say carpenters. These firms
nonunion workers.
need not be in the same industry; industries are defined according to the products
they produce and not the resources they employ. Thus, firms producing wood-
framed furniture, wood windows and doors, houses and apartment buildings, and
wood cabinets will demand carpenters. To find the total, or market, labour demand
curve for a particular labour service, we sum horizontally the labour demand curves
(the marginal revenue product curves) of the individual firms, as indicated in Figure
15-3 (Key Graph). The horizontal summing of the 200 labour demand curves like d
in Figure 15-3(b) yields the market labour demand curve D in Figure 15-3(a).

FIGURE 15-2 THE LONG-RUN TREND OF REAL WAGES IN CANADA

The productivity of S2020
Real wage rate (dollars)

Canadian labour has

increased substan-
tially over the long S2000
run, causing the S1950
demand for labour, S1900
D, to shift rightward D2020
(that is, to increase) D2000
more rapidly than D1950
increases in the
supply of labour, S.
D1900
The result has been
increases in real
0 Q
wages.
Quantity of labour
380 Part Three • Microeconomics of Resource Markets

Key Graph FIGURE 15-3LABOUR SUPPLY AND LABOUR DEMAND

IN (PANEL A) A PURELY COMPETITIVE LABOUR
MARKET AND (PANEL B) A SINGLE COMPETITIVE FIRM
S
a
Wage rate (dollars)

Wage rate (dollars)

e b
($10) Wc ($10) Wc s = MRC

D = MRP
(Σ mrp’s) c d = mrp
0 Qc Q 0 Qc Q
(1000) (5)
Quantity of labour Quantity of labour
(a) Labour market (b) Individual firm
In a purely competitive labour market (panel a), the equilibrium wage rate, Wc, and the number of workers, Qc, are deter-
mined by labour supply S and labour demand D. Because this market wage rate is given to the individual firm (panel b)
hiring in this market, its labour supply curve s = MRC is perfectly elastic. Its labour demand curve is its MRP curve (here
labelled mrp). The firm maximizes its profit by hiring workers up to where MRP = MRC. Area 0abc represents both the
firm’s total revenue and its total cost. The green area is its total wage cost; the lavender area is its nonlabour costs,
including a normal profit—that is, the firm’s payments to the suppliers of land, capital, and entrepreneurship.

Quick Quiz
1. The supply of labour curve S slopes upward in graph (a) because
a. the law of diminishing marginal utility applies.
b. the law of diminishing returns applies.
c. workers can afford to buy more leisure when their wage rates rise.
d. higher wages are needed to attract workers away from other labour markets,
household activities, and leisure.
2. This firm’s labour demand curve d in graph (b) slopes downward because
a. the law of diminishing marginal utility applies.
b. the law of diminishing returns applies.
c. the firm must lower its price to sell additional units of its product.
d. the firm is a competitive employer, not a monopsonist.
3. In employing five workers, the firm represented in graph (b)
a. has a total wage cost of $6000.
b. is adhering to the general principle of undertaking all actions for which the
marginal benefit exceeds the marginal cost.
c. uses less labour than would be ideal from society’s perspective.
d. experiences increasing marginal returns.
4. A rightward shift of the labour supply curve in graph (a) would shift curve
a. d = mrp leftward in graph (b).
b. d = mrp rightward in graph (b).
c. s = MRC upward in graph (b).
d. s = MRC downward in graph (b).
Answers
1. d; 2. b; 3. b; 4. d
 chapter fifteen • wage determination, discrimination, and immigration 381

Market Supply of Labour

On the supply side of a purely competitive labour market, we assume that no union
exists and that workers individually compete for available jobs. The supply curve
for each type of labour slopes upward, indicating that employers as a group must
pay higher wage rates to obtain more workers, because they must bid workers away
from other industries, occupations, and localities. Within limits, workers have alter-
native job opportunities: for example, they may work in other industries in the same
locality, or they may work in their present occupations in different cities or
provinces, or they may work in other occupations.
Firms that want to hire these workers (here, carpenters) must pay higher wage
rates to attract them away from the alternative job opportunities available to them.
They must also pay higher wages to induce people who are not currently in the
labour force—perhaps doing household activities or enjoying leisure—to seek
employment. In short, assuming that wages are constant in other labour markets,
higher wages in a particular labour market entice more workers to offer their labour
services in that market—a fact confirmed by the upward-sloping market supply of
labour curve S in Figure 15-3(a).

Labour Market Equilibrium

The intersection of the market labour demand curve and the market supply curve
determine the equilibrium wage rate and level of employment in purely competi-
tive labour markets. In Figure 15-3(a) the equilibrium wage rate is Wc ($10), and the
number of workers hired is Qc (1000). To the individual firm the market wage rate
Wc is given. Each of the many firms employs such a small fraction of the total avail-
able supply of this type of labour that none of them can influence the wage rate. The
supply of this labour is perfectly elastic to the individual firm, as shown by hori-
zontal line s in Figure 15-3(b).
Each individual firm will find it profitable to hire this type of labour up to the
point at which marginal revenue product is equal to marginal resource cost. This is
merely an application of the MRP = MRC rule we
developed in Chapter 14.
As Table 15-1 indicates, when the price of a
TABLE 15-1 THE SUPPLY OF
resource is given to the individual competitive
LABOUR: PURE
firm, the marginal cost of that resource (MRC) is
COMPETITION IN
constant and is equal to the resource price.
THE HIRE OF
Here, MRC is constant and is equal to the wage
LABOUR
rate. Each additional worker hired adds pre-
(1) (2) (3) (4) cisely his or her own wage rate ($10 in this case)
Units of Wage Total Marginal to the firm’s total resource cost. So the firm in a
labour rate labour cost resource purely competitive labour market maximizes
(wage bill) (labour) cost
its profit by hiring workers to the point at which
0 $10 $ 0 its wage rate equals MRP. In Figure 15-3(b) this
$10 firm will hire qc (five) workers, paying each of
1 10 10
10 them the market wage rate, Wc ($10). So, too,
2 10 20
10 will the other 199 firms (not shown) that are hir-
3 10 30 ing workers in this labour market.
10
4 10 40 To determine a firm’s total revenue from
10
5 10 50 employing a particular number of labour units,
10
6 10 60 we sum the MRPs of those units. For example, if
a firm employs three labour units with marginal
382 Part Three • Microeconomics of Resource Markets

revenue products of $14, $13, and $12, respectively, then the firm’s total revenue is
$39 (= $14 + $13 + $12). In Figure 15-3(b), where we are not restricted to whole units
of labour, total revenue is represented by area 0abc under the MRP curve to the left
of qc. What area represents the firm’s total cost, including a normal profit? For qc units,
the same area—0abc. The green rectangle represents the firm’s total wage cost (0qc ×
0Wc). The lavender triangle (total revenue minus total wage cost) represents the
firm’s nonlabour costs—its explicit and implicit payments to land, capital, and entre-
preneurship. Thus, in this case, total cost (wages plus other income payments) equals
total revenue. This firm and others like it are earning only a normal profit. Figure 15-
3(b) represents a long-run equilibrium for a firm that is selling its product in a purely
competitive product market and buying its labour in a purely competitive labour
market. (Key Questions 3 and 4)

Monopsony Model
In the purely competitive labour market described in the preceding section, each
employer hires too small an amount of labour to influence the wage rate. Each firm
can hire as little or as much labour as it needs but only at the market wage rate, as
reflected in its horizontal labour supply curve. The situation is quite different in
monopsony monopsony, a market in which a single employer of labour has substantial buying
A market structure (hiring) power. Labour market monopsony has the following characteristics:
in which there is
only a single buyer ● Only a single buyer of a particular type of labour exists.
of a good, service,
or resource. ● This type of labour is relatively immobile, either geographically or because
workers would have to acquire new skills.
● The firm is a wage-maker, because the wage rate it must pay varies directly
with the number of workers it employs.
As is true of monopoly power, there are various degrees of monopsony power. In
pure monopsony such power is at its maximum, because only a single employer
exists in the labour market. The best real-world examples are probably the labour
markets in some towns that depend almost entirely on one major firm. For exam-
ple, a copper-mining concern may be almost the only source of employment in a
remote British Columbia town. A textile mill in Quebec’s Eastern Townships, a
<www.idg.net/
crd_monopsony_
Gatineau papermill, or a Newfoundland fish processor may provide most of the
307867_103.html> employment in its locale. Inco (the largest nickel producer in the world) is a domi-
What is monopsony? nant employer in the Sudbury, Ontario, area.
In other cases three or four firms may each hire a large portion of the supply of
labour in a certain market and, therefore, have some monopsony power. If they tac-
itly or openly act in concert in hiring labour, they greatly enhance their monopsony
power.

Upward-Sloping Labour Supply to a Firm

When a firm hires most of the available supply of a particular type of labour, its
decision to employ more or fewer workers affects the wage rate it pays to those
workers. Specifically, if a firm is large in relation to the size of the labour market, it
will have to pay a higher wage rate to obtain more labour. Suppose only one
employer of a particular type of labour exists in a certain geographic area. In that
extreme case, the labour supply curve for that firm and the total supply curve for
the labour market are identical. This supply curve is upward sloping, indicating that
 chapter fifteen • wage determination, discrimination, and immigration 383

FIGURE 15-4 THE WAGE RATE AND LEVEL OF EMPLOYMENT IN A

MONOPSONISTIC LABOUR MARKET
In a monopsonistic labour
market, the employer’s mar- MRC S
ginal resource (labour) cost

Wage rate (dollars)

curve (MRC) lies above the b
labour supply curve, S.
Equating MRC with MRP at Wc a
point b, the monopsonist
hires Qm workers (compared Wm c
with Qc under competition). MRP
As indicated by point c on S,
it pays only wage rate Wm
(compared with the compet-
itive wage Wc).
0 Qm Qc Q
Quantity of labour

the firm must pay a higher wage rate to attract more workers. The supply curve, S
in Figure 15-4, is also the average-cost-of-labour curve for the firm; each point on it
indicates the wage rate (cost) per worker that must be paid to attract the corre-
sponding number of workers.

MRC Higher than the Wage Rate

When a monopsonist pays a higher wage to attract an additional worker, it must
pay that higher wage to all the workers it is currently employing at a lower wage.
If not, labour morale will deteriorate, and the employer will be plagued with labour
unrest because of wage-rate differences for the
same job. Paying a uniform wage to all workers
TABLE 15-2 THE SUPPLY means that the cost of an extra worker—the
OF LABOUR: marginal resource (labour) cost (MRC)—is the
MONOPSONY IN sum of that worker’s wage rate and the amount
THE HIRE OF necessary to bring the wage rate of all current
LABOUR workers up to the new wage level.
Table 15-2 illustrates this point. One worker
(1) (2) (3) (4)
Units of Wage Total Marginal can be hired at a wage rate of $6, but hiring a
labour rate labour cost resource second worker forces the firm to pay a higher
(wage bill) (labour) cost wage rate of $7. The marginal resource (labour)
cost of the second worker is $8—the $7 paid to
0 $ 5 $ 0
$ 6 the second worker plus a $1 raise for the first
1 6 6 worker. From another viewpoint, total labour
8
2 7 14 cost is now $14 (= 2 × $7), up from $6. So the
10
3 8 24 MRC of the second worker is $8 (= $14 – $6), not
12 just the $7 wage rate paid to that worker. Sim-
4 9 36
14 ilarly, the marginal labour cost of the third
5 10 50
16 worker is $10—the $8 that must be paid to attract
6 11 66
this worker from alternative employment, plus
$1 raises, from $7 to $8, for the first two workers.
384 Part Three • Microeconomics of Resource Markets

The important point is that to the monopsonist, marginal resource (labour) cost
exceeds the wage rate. Graphically, the MRC curve lies above the average-cost-of-
labour curve, or labour supply curve S, as is clearly shown in Figure 15-4.

Equilibrium Wage and Employment

How many units of labour will the monopsonist hire and what wage rate will it
pay? To maximize profit, the monopsonist will employ the quantity of labour Qm in
Figure 15-4, because at that quantity MRC and MRP are equal (point b).1 The
monopsonist next determines how much it must pay to attract these Qm workers.
From the supply curve S, specifically point c, it sees that it must pay wage rate Wm.
Clearly, it need not pay a wage equal to MRP; it can attract exactly the number of
workers it wants (Qm) with wage rate Wm. And that rate is what it will pay.
Contrast these results with those that would prevail in a competitive labour mar-
ket. With competition in the hiring of labour, the level of employment would be
greater (at Qc) and the wage rate would be higher (at Wc). Other things equal, the
monopsonist maximizes its profit by hiring a smaller number of workers and
thereby paying a less-than-competitive wage rate.2 Society gets a smaller output,
and workers get a wage rate that is less by bc than their marginal revenue product.
Just as a monopolistic seller finds it profitable to restrict product output to realize
an above-competitive price for its goods, the monopsonistic employer of resources
finds it profitable to restrict employment to depress wage rates and therefore
costs—that is, to realize wage rates below those that would occur under competi-
tive conditions.3

Examples of Monopsony Power

Monopsonistic labour markets are not common in the Canadian economy, since
more typically, many employers compete for workers, particularly for workers who
are occupationally and geographically mobile. Also, where monopsony labour

1The fact that MRC exceeds resource price when resources are hired or purchased under imper-
fectly competitive (monopsonistic) conditions calls for adjustments in Chapter 14’s least-cost and
profit-maximizing rules for hiring resources. (See equations (1) and (2) in the “Optimal Combi-
nation of Resources” section of Chapter 14.) Specifically, we must substitute MRC for resource
price in the denominators of our two equations. That is, with imperfect competition in the hiring
of both labour and capital, equation (1) becomes
MPL MPC
ᎏ =ᎏ (1⬘)
MRCL MRCC

and equation (2) is restated as

MRP MRPC
ᎏL = ᎏ (2⬘)
MRCL MRCC

In fact, equations (1) and (2) can be regarded as special cases of (1⬘) and (2⬘) in which firms hap-
pen to be hiring under purely competitive conditions and resource price is, therefore, equal to,
and can be substituted for, marginal resource cost.
2 This situation is analogous to the monopolist’s restricting output as it sets product price and out-

put based on marginal revenue, not product demand. In this instance, resource price is set on the
basis of marginal labour (resource) cost, not resource supply.
3
A monopsonistic employer may or may not be a monopolistic seller in the product market. The
Quebec textile mill may be a monopsonistic employer yet face severe domestic and foreign com-
petition in selling its product. In other cases—for example, the commercial aircraft and profes-
sional sports industries—firms have both monopsony and monopoly power.
 chapter fifteen • wage determination, discrimination, and immigration 385

market outcomes might otherwise occur, unions spring up to counteract that power
by forcing firms to negotiate wages. Nevertheless, economists have found evidence
of monopsony power in such diverse labour markets as the markets for nurses, pro-
fessional athletes, public-school teachers, newspaper employees, and some building
trades workers.
In the case of nurses, the major employers in most locales are a relatively small
number of hospitals. Further, the highly specialized skills of nurses are not readily
<www.bcnu.org/ transferable to other occupations. It has been found, in accordance with the monop-
backgrounder1.htm>
Nurses’ opening
sony model, that, other things equal, the smaller the number of hospitals in a town
demands in new or city (that is, the greater the degree of monopsony), the lower the starting salaries
collective agreement of nurses.
Professional sports leagues also provide a good example of monopsony, particu-
larly as it relates to the pay of first-year players. The National Hockey League, the
National Basketball Association, and Major League Baseball assign first-year play-
ers to teams through player drafts. That device prohibits other teams from compet-
ing for the player’s services, at least for several years, until the player becomes a free
agent. In this way the league exercises monopsony power, which results in lower
salaries than would occur under competitive conditions. (Key Question 6)

● Real wages have increased historically in Canada
because labour demand has increased relative
to labour supply.
● Over the long term, real wages per worker have
increased at approximately the same rate as
worker productivity.
● The labour supply curve for a monopsonist is
upward sloping, causing MRC to exceed the
wage rate for each worker. Other things equal,
the monopsonist, hiring where MRC = MRP, will
employ fewer workers and pay a lower wage
rate than would a purely competitive employer.

● The competitive employer is a wage-taker and

employs workers at the point where the wage
rate (= MRC) equals MRP.

Three Union Models

We have assumed so far that workers compete with one another in selling their
labour services. In some labour markets, however, workers sell their labour services
collectively through unions. When a union is formed in an otherwise competitive
labour market, it bargains with a relatively large number of employers. The union
has many goals, the most important of which is to raise wage rates, and it can pur-
sue that objective in several ways.

Demand-Enhancement Model
From the union’s viewpoint, the most desirable technique for raising wage rates is
to increase the demand for labour. As Figure 15-5 shows, an increase in labour
demand will create both higher wage rates and more jobs. How great those
increases will be depends on the elasticity of labour supply. The less elastic the
labour supply, the greater will be the wage increase; the more elastic the labour sup-
ply, the greater will be the employment increase.
386 Part Three • Microeconomics of Resource Markets

FIGURE 15-5 UNIONS AND THE DEMAND FOR LABOUR

When unions can
increase the demand S

Wage rate (dollars)

for labour (say, from
D1 to D2), they can
realize higher wage Increase
rates (Wc to Wu) and Wu in demand
more jobs (Qc to Qu). Wc
D2

D1

0 Qc Qu Q

Quantity of labour

To increase labour demand the union might alter one or more of the determinants
of demand. For example, a union can attempt to increase the demand for the prod-
uct or service its members are producing, enhance the productivity of labour, or
alter the prices of other inputs.

INCREASE PRODUCT DEMAND

To increase the demand for the products their members help produce—and thus to
increase the derived demand for labour services—unions may resort to advertising,
political lobbying, or requiring employers to hire redundant labour.
You may have seen ads placed by unions urging consumers to “look for the union
label.” On occasion, unions have joined with employers to finance advertising cam-
paigns designed to bolster demand for the products their members help to produce.
Unions in Canada have helped to finance “Buy Union” campaigns to convince con-
sumers to purchase products made by their members.
On the political front construction unions have lobbied for new highway, mass
transit, and stadium projects. Teachers’ unions and associations have pushed for
increased public spending on education, and the steelworkers’ union has at times
supported employers in seeking protective tariffs designed to exclude competing
foreign steel. The steelworkers recognize that an increase in the price of imported
steel through tariffs or international agreements will increase the demand for highly
substitutable domestically made steel, boosting the derived demand for Canadian
steelworkers.

INCREASE PRODUCTIVITY
Many decisions affecting labour productivity—for example, decisions concerning
the quantity and quality of real capital used by workers—are made unilaterally
by management. There is a growing tendency, however, to set up joint labour–
management committees designed to increase labour productivity.

RAISE THE PRICE OF OTHER INPUTS

Unions sometimes have tried to strengthen the demand for their labour by working
to increase the price of substitute resources. For example, although union members
 chapter fifteen • wage determination, discrimination, and immigration 387

are generally paid significantly more than the minimum wage, unions have strongly
supported increases in the minimum wage. The purpose may be to raise the price
of low-wage, nonunion labour, which in some cases is substitutable for union
labour. A higher minimum wage for nonunion workers will discourage employers
from substituting such workers for union workers and will thereby bolster the
demand for union members.
Similarly, unions have sometimes sought to increase the demand for their labour
by supporting public actions that reduce the price of a complementary resource. For
example, unions in industries that use large amounts of energy might oppose rate
increases proposed by electric or natural gas utilities. Where labour and energy are
complementary, a price increase for energy might reduce the demand for labour
through Chapter 14’s output effect.
Unions recognize that their ability to influence the demand for labour is very lim-
ited. Consequently they are more likely to try to prevent declines in labour demand
than they are to promote increases. So, it is not surprising that union efforts to raise
wage rates have concentrated on the supply side of the labour market.

Exclusive or Craft Union Model

One way in which unions can boost wage rates is to reduce the supply of labour, and
over the years organized labour has favoured policies to do just that. For example,
labour unions have supported legislation that has (1) restricted immigration, (2)
reduced child labour, (3) encouraged compulsory retirement, and (4) enforced a
shorter workweek.
Moreover, certain types of workers have adopted techniques designed to restrict
exclusive the number of workers who can join their union. This is especially true of craft unions,
unionism The whose members possess a particular skill, such as carpenters or brick masons or
practice of a labour plumbers. Craft unions have frequently forced employers to agree to hire only union
union of restricting members, thereby gaining virtually complete control of the labour supply. Then, by
the supply of skilled following restrictive membership policies—for example, long apprenticeships, very
union labour to
increase the wages
high initiation fees, and limits on the number of new members admitted—they arti-
received by union ficially restrict labour supply. As indicated in Figure 15-6, such practices result in
members. higher wage rates and constitute what is called exclusive unionism. By excluding

FIGURE 15-6 EXCLUSIVE OR CRAFT UNIONISM

By reducing the S2 S1
supply of labour (say,
Wage rate (dollars)

from S1 to S2) through

the use of restrictive
membership policies, Decrease
Wu in supply
exclusive unions
achieve higher wage Wc
rates (Wc to Wu).
However, restriction
of the labour supply
also reduces the D
number of workers
employed (Qc to Qu). 0 Qu Qc Q

Quantity of labour
388 Part Three • Microeconomics of Resource Markets

workers from unions and therefore from the labour supply, craft unions succeed in
elevating wage rates.
occupa- Occupational licensing is another means of restricting the supply of specific kinds
tional of labour. Here a group of workers in a given occupation pressure provincial or munic-
licensing ipal governments to pass a law that says that some occupational group (for example,
The laws of provin-
cial or municipal
barbers, or physicians, plumbers, cosmetologists, egg graders, pest controllers) can
governments that practise their trade only if they meet certain requirements. Those requirements might
require a worker to include level of education, amount of work experience, the passing of an examination,
satisfy certain speci- and personal characteristics (“the practitioner must be of good moral character”).
fied requirements Members of the licensed occupation typically dominate the licensing board that
and obtain a licence
from a licensing
administers such laws. The result is self-regulation, which often leads to policies that
board before serve only to restrict entry to the occupation and reduce the labour supply.
engaging in a par- The purpose of licensing is supposedly to protect consumers from incompetent
ticular occupation. practitioners—surely a worthy goal. But such licensing also results in above-
competitive wages and earnings for those in the licensed occupation (Figure 15-6).
Moreover, licensing requirements often include a residency requirement, which
inhibits the interprovincial movement of qualified workers. Some 300 occupations
are now licensed in Canada.

Inclusive or Industrial Union Model

Instead of trying to limit their membership, however, most unions seek to organize
all available workers. This is especially true of the industrial unions, such as those of
the automobile workers and steelworkers. Such unions seek as members all avail-
able unskilled, semiskilled, and skilled workers in an industry. A union can afford
to be exclusive when its members are skilled craft persons for whom there are few
<www.amfanow.org/
craft.htm>
substitutes. But for a union composed of unskilled and semiskilled workers, a pol-
Craft union or icy of limited membership would make available to the employers numerous
industrial union? nonunion workers who are highly substitutable for the union workers.
An industrial union that includes virtually all available workers in its member-
ship can put firms under great pressure to agree to its wage demands. Because of its
legal right to strike, such a union can threaten to deprive firms of their entire labour
supply, and an actual strike can do just that.
inclusive We illustrate such inclusive unionism in Figure 15-7. Initially, the competitive
unionsim The equilibrium wage rate is Wc and the level of employment is Qc. Now suppose an
practice of a labour industrial union is formed that demands a higher, above-equilibrium wage rate of,
union of including
as members all
say, Wu. That wage rate Wu would create a perfectly elastic labour supply over the
workers employed range ae in Figure 15-7. If firms wanted to hire any workers in this range, they would
in an industry. have to pay the union-imposed wage rate. If they decide against meeting this wage
demand, the union will supply no labour at all, and the firms will be faced with a
strike. If firms decide it is better to pay the higher wage rate than to suffer a strike,
they will cut back on employment from Qc to Qu.
By agreeing to the union’s Wu wage demand, individual employers become
wage-takers. Because labour supply is perfectly elastic over range ae, the marginal
resource (labour) cost is equal to the wage rate Wu over this range. The Qu level of
employment is the result of employers’ equating this MRC (now equal to the wage
rate) with MRP, according to our profit-maximizing rule.
Note from point e on labour supply curve S that Qe workers desire employment
at wage Wu. But as indicated by point b on labour demand curve D, only Qu work-
ers are employed. The result is a surplus of labour of Qe – Qu (also shown by distance
eb). In a purely competitive labour market without the union, the effect of a surplus
 chapter fifteen • wage determination, discrimination, and immigration 389

FIGURE 15-7 INCLUSIVE OR INDUSTRIAL UNIONISM

By organizing virtu- S
ally all available

Wage rate (dollars)

workers to control
the supply of labour,
a b
inclusive industrial Wu e
unions may impose a
wage rate, such as Wc
Wu, which is above
the competitive wage
rate Wc. The effect is
to change the labour D
supply curve from S
to aeS. At wage rate 0 Qu Qc Qe Q
Wu, employers will
cut employment from
Qc to Qu. Quantity of labour

of unemployed workers would be lower wages. Specifically, the wage rate would
fall to the equilibrium level, Wc, where the quantity of labour supplied equals the
quantity of labour demanded (each Qc). But this drop in wages does not happen,
because workers are acting collectively through their union. Individual workers
cannot offer to work for less than Wu; nor can employers pay less than that.

Wage Increases and Unemployment

Have unions been successful in raising the wages of their members? Evidence sug-
gests that union members on average achieve a 10 to 15 percent wage advantage
over nonunion workers.
As Figures 15-6 and 15-7 suggest, the effect of wage-raising actions achieved by
both exclusive and inclusive unionism is to reduce employment. A union’s success
in achieving above-equilibrium wage rates thus tends to be accompanied by a
decline in the number of workers employed. That result acts as a restraining influ-
ence on union wage demands. A union cannot expect to maintain solidarity within
its ranks if it demands a wage rate so high that joblessness will result for, say, 20 or
30 percent of its members.
The unemployment effect created by union-induced wage increases may be
reduced in two ways:
1. Growth The normal growth of the economy increases the demand for most
kinds of labour over time. This continual rightward shift of the labour demand
curves in Figures 15-6 and 15-7 might offset, or more than offset, the unemploy-
ment effects associated with the indicated wage increases. In that event, the
increases in unemployment prompted by the unions would tend to slow the
growth of job opportunities but would not reduce total employment by firms.
2. Elasticity The size of the unemployment effect resulting from a union-induced
wage increase depends on the elasticity of demand for labour. The more inelas-
tic that demand, the smaller the amount of unemployment that accompanies a
given wage-rate increase. And if unions have sufficient bargaining strength, they
may be able to win provisions in their collective bargaining agreements that
390 Part Three • Microeconomics of Resource Markets

reduce the elasticity of demand for union labour by reducing the substitutabil-
ity of other inputs for that labour. For example, a union may force employers to
accept rules slowing the introduction of new machinery and equipment. Or the
union may bargain successfully for severance pay or layoff pay, which increases
the cost to the firm of substituting capital for labour when wage rates are
increased. Similarly, the union may gain a contract provision prohibiting the firm
from subcontracting production to nonunion (lower-wage) firms or from relo-
cating work to low-wage workers overseas, thereby restricting the substitution
of cheaper labour for union workers.

Bilateral Monopoly Model

Suppose a strong industrial union is formed in a labour market that is monopson-
istic rather than competitive, creating a combination of the monopsony model and
bilateral the inclusive unionism model. The result is called bilateral monopoly because in its
monopoly A pure form there is a single seller and a single buyer. The union is a monopolistic
market in which “seller” of labour that controls labour supply and can influence wage rates, but it
there is a single
seller (monopoly)
faces a monopsonistic “buyer” of labour that can also affect wages by altering its
and a single buyer employment. This is not an uncommon case, particularly in less-pure forms in
(monopsony). which a single union confronts two, three, or four large employers, such as steel,
automobiles, construction equipment, professional sports, and commercial aircraft.

Indeterminate Outcome of Bilateral Monopoly

This situation is shown in Figure 15-8, where we superimpose Figure 15-7 onto Fig-
ure 15-4. The monopsonistic employer will seek the below-competitive-equilibrium
wage rate Wm, and the union presumably will press for some above-competitive-
equilibrium wage rate such as Wu. Which will be the outcome? We cannot say with
certainty. The outcome is logically indeterminate because the bilateral monopoly
model does not explain what will happen at the collective bargaining table. We can
expect the wage outcome to lie somewhere between Wm and Wu. Beyond that, about
all we can say is that the party with the greater bargaining power and the more
effective bargaining strategy will probably get a wage closer to the one it seeks.

FIGURE 15-8 BILATERAL MONOPOLY IN THE LABOUR MARKET

A monopsonist seeks MRC S
to hire Qm workers
(where MRC = MRP)
Wage rate (dollars)

and pay wage rate

Wm corresponding to Wu
Qm labour on labour
supply curve S. The Wc a
inclusive union it
faces seeks the Wm
above-equilibrium
wage rate Wu. The
actual outcome can- D = MRP
not be predicted by
economic theory. 0 Qu = Qm Qc Q
Quantity of labour
 chapter fifteen • wage determination, discrimination, and immigration 391

Desirability of Bilateral Monopoly

The wage and employment outcomes in this situation might be more socially desir-
able than the term “bilateral monopoly” implies. The monopoly on one side of the
market might in effect cancel out the monopoly on the other side, yielding compet-
itive or near-competitive results. If either the union or management prevailed in this
market—that is, if the actual wage rate were determined at either Wu or Wm—
employment would be restricted to Qm (where MRP = MRC), which is below the
competitive level.
But now suppose the monopoly power of the union roughly offsets the monop-
sony power of management, and the union and management agree on wage rate Wc,
which is the competitive wage. Once management accepts this wage rate, its incen-
tive to restrict employment disappears; no longer can it depress wage rates by
restricting employment. Instead, management hires at the most profitable resource
quantity, where the bargained wage rate Wc (which is now the firm’s MRC) is equal
to the MRP. It hires Qc workers. Thus, with monopoly on both sides of the labour
market, the resulting wage rate and level of employment may be closer to compet-
itive levels than would be the case if monopoly existed on only one side of the mar-
ket. (Key Question 7)

● In the demand-enhancement union model, a ● In the inclusive (industrial) union model, a

union increases the wage rate by increasing
labour demand through actions that increase
product demand, raise labour productivity, or
alter the prices of related inputs.
● In the exclusive (craft) union model, a union
increases wage rates by artificially restricting
labour supply, through, say, long apprentice-
ships or occupational licensing.
union raises the wage rate by gaining control
over a firm’s labour supply and threatening to
withhold labour via a strike unless a negotiated
wage is obtained.
● Bilateral monopoly occurs in a labour market
where a monopsonist bargains with an inclu-
sive, or industrial, union. Wage and employ-
ment outcomes are determined by collective
bargaining in this situation.

The Minimum-Wage Controversy

minimum In Canada both the federal and provincial governments have enacted minimum
wage The lowest wage legislation, but it is the provincial governments’ that cover most workers. The
wage employers provincial minimum wage ranges from $5.50 per hour in Newfoundland and Prince
may legally pay for
an hour of work. Edward Island to $8.00 per hour in British Columbia. The purpose of the minimum
wage is to provide a living wage that will allow less-skilled workers to earn enough
for them and their children to escape poverty.

Case Against the Minimum Wage

Critics, reasoning in terms of Figure 15-7, contend that an above-equilibrium mini-
<info.load-otea.hrdc-
mum wage (say, Wu) will simply push employers back up their labour demand
drhc.gc.ca/~legweb/
clc3/legislation/ curves, causing them to hire fewer workers. The higher labour costs may even force
l3tocen.htm> some firms out of business. Then, some of the poor, low-wage workers whom the
Canada’s Labour Code minimum wage was designed to help will find themselves out of work. Critics point
392 Part Three • Microeconomics of Resource Markets

out that a worker who is unemployed at a minimum wage of $5.00 per hour is clearly
worse off than if employed at a market wage rate of, say, $4.50 per hour.
A second criticism of the minimum wage is that it is poorly targeted to reduce
poverty. Critics point out that much of the benefit of the minimum wage accrues to
teenage workers, most of whom receive only minimum wages for just a few years.

Case for the Minimum Wage

Advocates of the minimum wage say that critics analyze its impact in an unrealis-
tic context. Figure 15-7, advocates claim, assumes a competitive, static market. But
in a more realistic, low-pay labour market where there is some monopsony power
(Figure 15-8), the minimum wage can increase wage rates without causing unem-
ployment. Indeed, a higher minimum wage may even produce more jobs by elimi-
nating the motive that monopsonistic firms have for restricting employment. For
example, a minimum wage floor of Wc in Figure 15-8 would change the firm’s
labour supply curve to WcaS and prompt the firm to increase its employment from
Qm workers to Qc workers.
A minimum wage may increase labour productivity, shifting the labour demand
curve to the right and offsetting any reduced employment that the minimum wage
might cause. For example, the higher wage rate might prompt firms to find more
productive tasks for low-paid workers, thereby raising their productivity. Alterna-
tively, the minimum wage may reduce labour turnover (the rate at which workers
voluntarily quit). With fewer low-productive trainees, the average productivity of
the firm’s workers would rise. In either case, the higher labour productivity would
justify paying the higher minimum wage. So, the alleged negative employment
effects of the minimum wage might not occur.

Evidence and Conclusions

Which view is correct? Unfortunately, there is no clear answer. All economists agree
there is some minimum wage so high that it would severely reduce employment.
Consider $20 an hour, as an absurd example. But no current consensus exists on the
employment effects of the present level of the minimum wage. Evidence in the 1980s
suggested that minimum wage hikes reduced employment of minimum wage
workers, particularly teenagers (16- to 19-year-olds). The consensus then was that a
10 percent increase in the minimum wage would reduce teenage employment by
about 1 to 3 percent. But Canadian evidence suggests that the minimum wage hikes
in the 1990s produced even smaller, and perhaps zero, employment declines among
teenagers.4
The overall effect of the minimum wage is thus uncertain. On the one hand, the
employment and unemployment effects of the minimum wage do not appear to be
a great as many critics fear. On the other hand, because a large part of its effect is
dissipated on nonpoverty families, the minimum wage is not as strong an anti-
poverty tool as many supporters contend.
It is clear, however, that the minimum wage has strong political support. Perhaps
this stems from two realities: (1) more workers are helped by the minimum wage
than are hurt and (2) the minimum wage gives society some assurance that employ-
ers are not taking undo advantage of vulnerable, low-skilled workers.

4
Alan Krueger, “Teaching the Minimum Wage in Econ 101 in Light of the New Economics of the
Minimum Wage,” Journal of Economic Education (forthcoming).
 chapter fifteen • wage determination, discrimination, and immigration 393

Wage Differentials
Hourly wage rates and annual salaries differ greatly among occupations. In Table
15-3 we list average weekly wages for several industries to illustrate such occupational
wage differ- wage differentials. For example, observe that construction workers on average earn
entials The almost a third more than those workers in the health and service industry. Large wage
difference between differentials also exist within some of the occupations listed (not shown). For example,
the wage received
by one worker or
although average wages for retail salespersons are relatively low, some top salesper-
group of workers sons selling on commission make several times the average wages for their occupation.
and that received by What explains wage differentials such as these? Once again, the forces of demand and
another worker or supply are revealing. As we demonstrate in Figure 15-9, wage differentials can arise on
group of workers. either the supply or demand side of labour markets. Figures 15-9(a) and (b) represent
labour markets for two occupational groups that have identical labour supply curves. The
labour market in panel a has a relatively high equilibrium wage (Wa) because labour
demand is very strong. The labour market in panel b has an equilibrium wage that is rel-
atively low (Wb) since labour demand is weak. Clearly, the wage differential between
occupations (a) and (b) results solely from differences in the magnitude of labour demand.
Contrast that situation with Figure 15-9(c) and (d), where the labour demand
curves are identical. In the labour market in panel (c), the equilibrium wage is rela-
tively high (Wc) because labour supply is highly restricted. In the labour market in
marginal panel (d) labour supply is highly abundant, so the equilibrium wage (Wd) is rela-
revenue tively low. The wage differential between (c) and (d) results solely from the differ-
productivity ences in the magnitude of the labour supply.
How much workers
contribute to their Although Figure 15-9 provides a good starting point for understanding wage dif-
employers’ revenue. ferentials, we need to know why demand and supply conditions differ in various
labour markets.

TABLE 15-3 AVERAGE Marginal Revenue Productivity

WEEKLY WAGES The strength of labour demand—how far rightward
IN SELECTED the labour demand curve is located—differs greatly
INDUSTRIES, 2000 among occupations because of differences in how
Average weekly much various occupational groups contribute to
earnings their employers’ revenue. This revenue contribution,
(including in turn, depends on the workers’ productivity and
Industry overtime) the strength of the demand for the products they are
All industries $ 626.45 helping to produce. Where labour is highly produc-
tive and product demand is strong, labour demand
Mining, quarrying, and oil wells 1,152.60
also is strong, and other things equal, pay is high.
Logging and forestry 821.23 Top professional athletes, for example, are highly
Transportation, storage, productive at sports entertainment, for which mil-
communications, and other utilities 779.32 lions of people are willing to pay billions of dollars
Manufacturing 778.30 over the course of a season. So the marginal revenue
Finance, insurance, and real estate 777.52 productivity of these top players is exceptionally
high, as are their salaries, represented in Figure
Construction 722.84
15-9(a). In contrast, in most occupations workers
Educational and related services 672.88 generate much more modest revenue for their
Health and social services 542.25 employers, so their pay is lower, as in Figure 15-9(b).
Trade 476.48
Noncompeting Groups
Source: Statistics Canada, <www.statcan.ca/english/Pgdb>.
Visit www.mcgrawhill.ca/college/mcconnell9 for data update. On the supply side of the labour market, workers
are not homogeneous; they differ in their mental
394 Part Three • Microeconomics of Resource Markets

FIGURE 15-9 LABOUR DEMAND, LABOUR SUPPLY, AND WAGE

DIFFERENTIALS
The wage differential W W
Sa
between labour Sb
markets (a) and
(b) results solely from Wa
differences in labour
demand. In labour
market (c) and
(d), differences in
labour supply cause Wb
the wage differential. Da

Db

0 Qa Q 0 Qb Q

(a) Strong labour demand (b) Weak labour demand

W W
Sc

Sd
Wc

Wd

Dc Dd

0 Qc Q 0 Qd Q

(c) Restricted labour supply (d) Abundant labour supply

and physical capacities and in their education and training. At any given time the
non- labour force is made up of many noncompeting groups of workers, each repre-
competing senting several occupations for which the members of a particular group qualify. In
groups Collec- some groups qualified workers are relatively few, whereas in others they are highly
tions of workers in
the economy who
abundant. Workers in one group do not qualify for the occupations of other groups.
do not compete
with each other ABILITY
for employment Only a few workers have the ability or physical attributes to be brain surgeons, con-
because the skill
and training of
cert violinists, top fashion models, research scientists, or professional athletes.
the workers in one Because the supply of these particular types of labour is very small in relation to
group are substan- labour demand, their wages are high, as in Figure 15-9(c). The members of these and
tially different similar groups do not compete with one another or with other skilled or semiskilled
from those in other workers. The violinist does not compete with the surgeon, nor does the surgeon
groups.
compete with the violinist or the fashion model.
The concept of noncompeting groups can be applied to various subgroups and
even to specific individuals in a particular group. An especially skilled violinist can
 chapter fifteen • wage determination, discrimination, and immigration 395

command a higher salary than colleagues who play the same instrument. A handful
of top corporate executives earn 10 to 20 times as much as the average chief execu-
tive officer. In each of these cases, the supply of top talent is highly limited, since less
talented colleagues are only imperfect substitutes.

EDUCATION AND TRAINING

Another source of wage differentials has to do with differing amounts of investment
investment in human capital. An investment in human capital is an expenditure on education
in human or training that improves the skills and, therefore, the productivity of workers. Like expen-
capital Any ditures on machinery and equipment, expenditures on education or training that
expenditure under-
taken to improve
increase a worker’s productivity can be regarded as investments. In both cases, cur-
the education, skills, rent costs are incurred with the intention that will lead to a greater future flow of
health, or mobility earnings.
of workers, with Although education yields higher incomes, it carries substantial costs. A college
an expectation of or university education involves not only direct costs (tuition, fees, books) but indi-
greater productivity
and thus a positive
rect or opportunity costs (forgone earnings) as well. Does the higher pay received
return on the by better-educated workers compensate for these costs? The answer is yes. Rates of
investment. return are estimated to be 10 to 13 percent for investments in secondary education
and 8 to 12 percent for investments in college and university education. One gener-
ally accepted estimate is that each year of schooling raises a worker’s wage by about
8 percent. Also, the pay gap between college and university graduates and high-
school graduates increased sharply between 1980 and 2000.

Compensating Differences
If the workers in a particular noncompeting group are equally capable of perform-
ing several different jobs, you might expect the wage rates to be identical for all
these jobs. Not so. A group of high-school graduates may be equally capable of
becoming sales clerks or construction workers, but these jobs pay different wages.
In virtually all locales, construction labourers receive much higher wages than sales
compen- clerks. These wage differentials are called compensating differences, because they
sating must be paid to compensate for nonmonetary differences in various jobs.
differences The construction job involves dirty hands, a sore back, the hazard of accidents,
Differences in the
wages received by and irregular employment, both seasonally and cyclically. The retail sales job means
workers in different clean clothing, pleasant air-conditioned surroundings, and little fear of injury or lay-
jobs to compensate off. Other things equal, it is easy to see why some workers would rather pick up a
for nonmonetary credit card than a shovel. So labour supply is more limited for construction firms,
differences in the as in Figure 15-9(c), than for retail shops, as in Figure 15-9(d). Construction firms
jobs.
must pay higher wages than retailers to compensate for the unattractive nonmone-
tary aspects of construction jobs.
Compensating differences play an important role in allocating society’s scarce
labour resources. If very few workers want to be garbage collectors, then society
must pay high wages to garbage collectors to get the garbage collected. If many
more people want to be sales clerks, then society need not pay them as much as
garbage collectors to get those services performed.

Market Imperfections
The ideas of marginal revenue productivity, noncompeting groups, and differences
in nonmonetary aspects of jobs explain many of the wage differentials in the econ-
omy. But other persistent differentials result from several types of market imperfec-
tions that impede workers from leaving their current jobs to take higher-paying jobs.
396 Part Three • Microeconomics of Resource Markets

LACK OF JOB INFORMATION

Workers may simply be unaware of job opportunities and wage rates in other
geographic areas and in other jobs for which they qualify. Consequently, the
flow of qualified labour from lower-paying to higher-paying jobs—and thus the
adjustments in labour supply—may not be sufficient to equalize wages within
occupations.

GEOGRAPHIC IMMOBILITY
Workers take root geographically. Many are reluctant to move to new places, to
leave friends, relatives, and associates, to force their children to change schools, to
sell their houses, or to incur the costs and inconveniences of adjusting to a new job
and a new community. As Adam Smith noted more than two centuries ago, “A [per-
son] is of all sorts of luggage the most difficult to be transported.” The reluctance or
inability of workers to move creates geographic wage differentials within the same
occupation to persist.

UNIONS AND GOVERNMENT RESTRAINTS

Wage differentials may be reinforced by artificial restrictions on mobility imposed by
unions and government. We have noted that craft unions find it to their advantage
to restrict membership. After all, if carpenters and bricklayers become too plentiful,
the wages they can command will decline. Thus, the low-paid nonunion carpenter
of Edmonton, Alberta, may be willing to move to Vancouver in the pursuit of higher
wages, but her chances for succeeding are slim. She may be unable to get a union
card, and no card means no job. Similarly, an optometrist or lawyer qualified to prac-
tise in one province may not meet licensing requirements of other provinces, so his
ability to move is limited. Other artificial barriers involve pension plans and senior-
ity rights that might be jeopardized by moving from one job to another.

DISCRIMINATION
Despite legislation to the contrary, discrimination sometimes results in lower wages
being paid to women and visible-minority workers than to white males doing vir-
tually identical work. Also, women and minorities may be crowded into certain
low-paying occupations, driving down wages there and raising them elsewhere.
If discrimination keeps qualified women and minorities from taking the higher-
paying jobs, then differences in pay will persist.
All four considerations—differences in marginal revenue productivity, noncom-
peting groups, nonmonetary differences, and market imperfections—come into
play in explaining actual wage differentials. For example, the differential between
the wages of a physician and those of a construction worker can be explained based
on marginal revenue productivity and noncompeting groups. Physicians generate
considerable revenue because of their high productivity and the strong willingness
of consumers (via provincial governments) to pay for health care. Physicians also
fall into a noncompeting group where, because of stringent training requirements,
only a relatively few persons qualify. So the supply of labour is small in relation
to demand.
In some construction work, where training requirements are much less signifi-
cant, the supply of labour is great relative to demand, so, wages are much lower for
construction workers than for physicians. However, if not for the unpleasantness of
the construction worker’s job and the fact that the craft union observes restrictive
membership policies, the differential would be even greater than it is.
 chapter fifteen • wage determination, discrimination, and immigration 397

Pay for Performance

The models of wage determination we have described in this chapter assume that
worker pay is always a standard amount for each hour’s work, for example, $15 per
hour. But pay schemes are often more complex than that in both composition and
purpose. For instance, many workers receive annual salaries rather than hourly pay.
Many workers also receive fringe benefits: dental insurance, life insurance, paid
vacations, paid sick-leave days, pension contributions, and so on. Finally, some pay
plans are designed to elicit a desired level of performance from workers. This last
aspect of pay plans requires further elaboration.

The Principal–Agent Problem Revisited

In Chapter 3 we first identified the principal–agent problem as it relates to possible dif-
ferences in the interests of corporate stockholders (principals) and the executives
(agents) they hire. This problem extends to all workers. Firms hire workers because
they are needed to help produce the goods and services the firms sell for a profit.
Workers are the firms’ agents; they are hired to advance the interest (profit) of the
firms. The principals are the firms; they hire agents to advance their goals. Firms
and workers have one interest in common: they both want the firm to survive and
thrive. That will ensure profit for the firm and continued employment and wages for
the workers.
But the interests of the firm and of the workers are not identical. A principal–
agent problem arises when those interests diverge. Workers may seek to increase
their utility by shirking on the job, that is, by providing less than the agreed-on
effort or by taking unauthorized breaks. They may improve their well-being by
increasing their leisure, during paid work hours, without forfeiting income. The
night security guard in a warehouse may leave work early or spend time reading a
novel rather than making the assigned rounds. A salaried manager may spend time
away from the office visiting friends rather than attending to company business.
Firms (principals) have a profit incentive to reduce or eliminate shirking. One
option is to monitor workers, but monitoring is difficult and costly. Hiring another
worker to supervise or monitor the security guard might double the cost of main-
taining a secure warehouse. Another way of resolving the principal–agent problem
incentive is through some sort of incentive pay plan that ties worker compensation more
pay plan A closely to output or performance. Such incentive pay schemes include piece rates,
compensation commissions and royalties, bonuses and profit sharing, and efficiency wages.
structure that ties
worker pay directly
to performance PIECE RATES
such as piece rates, Piece rates consist of compensation paid according to the number of units of output
bonuses, stock a worker produces. If a principal pays fruit pickers by the bushel or typists by the
options, commis-
sions, and profit
page, it need not be concerned with shirking or with monitoring costs.
sharing.
COMMISSIONS OR ROYALTIES
Unlike piece rates, commissions and royalties tie compensation to the value of sales.
Employees who sell products or services—including real estate agents, insurance
agents, stockbrokers, and retail salespersons—commonly receive commissions that
are computed as a percentage of the monetary value of their sales. Recording artists
and authors are paid royalties, computed as a certain percentage of sales revenues
from their works. Such types of compensation link the financial interests of the
salespeople or artists and authors to the profit interest of the firms.
398 Part Three • Microeconomics of Resource Markets

BONUSES, STOCK OPTIONS, AND PROFIT SHARING

Bonuses are payments in addition to one’s annual salary that are based on some fac-
tor such as the performance of the individual worker, or of a group of workers, or of
the firm itself. A professional baseball player may receive a bonus based on a high bat-
ting average, the number of home runs hit, or the number of runs batted in. A busi-
ness manager may receive a bonus based on the profitability of her or his unit. Stock
options allow workers to buy shares of their employer’s stock at a fixed, lower price
when the stock price rises. Such options are part of the compensation packages of top
corporate officials, as well as many workers in relatively new high technology firms.
Profit-sharing plans allocate a percentage of a firm’s profit to its employees. Such plans
have in recent years resulted in large annual payments to many Canadian workers.

EFFICIENCY WAGES
The rationale behind efficiency wages is that employers will enjoy greater effort from
their workers by paying them above-equilibrium wage rates. Glance back at Figure
15-3, which shows a competitive labour market in which the equilibrium wage rate
is $10. What if an employer decides to pay an above-equilibrium wage of $12 per
hour? Rather than putting the firm at a cost disadvantage compared with rival firms
paying only $10, the higher wage might improve worker effort and productivity so
that unit labour costs actually fall. For example, if each worker produces 10 units of
output per hour at the $12 wage rate compared with only 6 units at the $10 wage
rate, unit labour costs for the high-wage firm will be only $1.20 (= $12 ÷ 10) com-
pared to $1.67 (= $10 ÷ 6) for firms paying the equilibrium wage.
An above-equilibrium wage may enhance worker efficiency in several ways. It
enables the firm to attract higher-quality workers, it lifts worker morale, and it low-
ers turnover, resulting in a more experienced workforce, greater worker productiv-
ity, and lower recruitment and training costs. Because the opportunity cost of losing
a higher-wage job is greater, workers are more likely to put forth their best efforts
with less supervision and monitoring. In fact, efficiency wage payments have
proven effective for many employers.

Addenda: The Negative Side Effects of Pay for Performance

Although pay for performance may help to overcome the principal–agent problem
and enhance worker productivity, such plans may have negative side effects and so
require careful design. Here are a few examples:
● The rapid production pace that piece rates encourage may result in poor prod-
uct quality and may compromise the safety of workers. Such outcomes can be
costly to the firm over the long run.
● Commissions may cause some salespeople to engage in questionable or even
fraudulent sales practices, such as making exaggerated claims about products
or recommending unneeded repairs. Such practices may lead to private law-
suits or government legal action.
● Bonuses based on personal performance may disrupt the close cooperation
needed for maximum team production. A professional basketball player who
receives a bonus for points scored may be reluctant to pass the ball to teammates.
● Since profit sharing is usually tied to the performance of the entire firm, less
energetic workers can free-ride by obtaining their profit share based on the
hard work of others.
 chapter fifteen • wage determination, discrimination, and immigration 399

● There may be a downside to the reduced turnover resulting from above-market

wages: Firms that pay efficiency wages have fewer opportunities to hire new
workers and suffer the loss of new blood that sometimes energizes the workplace.

● Proponents of the minimum wage argue that it
is needed to assist the working poor and to
counter monopsony where it might exist; critics
say that it is poorly targeted to reduce poverty
and that it reduces employment.
● Wage differentials are generally attributable to
the forces of supply and demand, influenced by
differences in workers’ marginal revenue pro-
ductivity, workers’ education and skills, and non-
monetary differences in jobs. Several labour
market imperfections also play a role.
● As it applies to labour, the principal–agent prob-
lem is one of workers pursuing their own inter-
ests to the detriment of the employer’s profit
objective.
● Pay-for-performance plans (piece rates, com-
missions, royalties, bonuses, profit sharing, and
efficiency wages) are designed to improve
worker productivity by overcoming the principal–
agent problem.

Labour Market Discrimination

Broadly defined, labour market discrimination occurs when equivalent labour
resources are paid or treated differently even though their productive contributions
are equal. These differences result from a combination of nondiscriminatory and
discriminatory factors. For example, studies indicate that about one-half the differ-
ences in earnings between men and women and between whites and visible minori-
ties can be explained by such nondiscriminatory factors as differences in education,
<is.dal.ca/~eequity/ age, training, industry and occupation, union membership, location, work experi-
INFO/question.htm>
Frequently asked
ence, continuity of work, and health. (Of course, some of these factors may be influ-
employment equity enced by discrimination.) The other half is an unexplained difference, the bulk of
questions which economists attribute to discrimination
In labour market discrimination, certain groups of people are often accorded infe-
rior treatment with respect to hiring, occupational access, education and training,
promotion, wage rates, or working conditions even though they have the same abil-
ities, education and training, and experience as the more preferred groups. People
who practise discrimination are said to exhibit a prejudice or bias against the targets
of their discrimination.

Types of Discrimination
wage dis- Labour market discrimination may take several forms:
crimination
The payment of a ● Wage discrimination occurs when women or members of minorities are paid
lower wage to less than white males for doing the same work. This kind of discrimination is
members of a less- declining because of its explicitness and the fact that it clearly violates federal
preferred group law. But wage discrimination can be subtle and difficult to detect. For exam-
than to members of
a more-preferred
ple, women and minorities sometimes find that their job classifications carry
group for the same lower pay than job classifications held by white males, even though they are
work. performing essentially the same tasks.
400 Part Three • Microeconomics of Resource Markets

employment ● Employment discrimination takes place when women or visible-minority

discrimina- workers receive inferior treatment in hiring, promotions, assignments, tem-
tion Inferior porary layoffs, and permanent discharges. This type of discrimination also
treatment in hiring,
promotion, and
encompasses sexual and racial harassment—demeaning treatment in the
work assignment workplace by coworkers or administrators.
for a particular
group of employees.
● Occupational discrimination occurs when women or visible-minority work-
ers are arbitrarily restricted or prohibited from entering the more desirable,
occupa- higher-paying occupations. Businesswomen have found it difficult to break
tional dis- through the “glass ceiling” that prevents them from moving up to executive
crimination ranks. Visible minorities in executive and sales positions are relatively rare. In
Arbitrary restriction
of particular groups
addition, skilled and unionized work such as electrical work, bricklaying, and
from more desir- plumbing do not have high visible minority representation.
able, higher-paying
occupations.
● Human capital discrimination occurs when women or members of minorities
do not have the same access to productivity-enhancing investments in education
human and training as white males. For example, the lower average educational attain-
capital ment of visible minorities has reduced their opportunities in the labour market.
discrimina-
tion Arbitrary
restriction of par- Costs of Discrimination
ticular groups
from productivity-
Discrimination imposes costs on those who are discriminated against. The groups
enhancing invest- that discriminate get the good jobs and the better pay that are withheld from the tar-
ments in education gets of discrimination. But discrimination does more than simply transfer benefits
and training. from women and visible minorities to men and whites; where it exists, discrimina-
tion actually diminishes the economy’s output and income; like any other artificial
barrier to free competition, it decreases economic efficiency and reduces production.
By arbitrarily blocking certain qualified groups of people from high-productivity
(and thus high-wage) jobs, discrimination prevents them from making their maxi-
mum contribution to society’s output, income, and well-being.
The effects of discrimination can be depicted as a point inside the economy’s pro-
duction possibilities curve, such as point D in Figure 15-10. At such a point, the econ-
omy obtains some combination of capital and consumption goods—here, Kd +
Cd—that is less desirable than combinations represented by points such as X, Y, or Z
on the curve. By preventing the economy from achieving productive efficiency, dis-
crimination reduces the nation’s real output and income. Very rough estimates suggest
that the Canadian economy would gain $32 billion per year by eliminating racial and
ethnic discrimination and some $18 billion per year by ending gender discrimination.

Economic Analysis of Discrimination

Prejudice reflects complex, multifaceted, and deeply ingrained beliefs and atti-
tudes. Thus, economics can contribute some insight into discrimination but no
detailed explanations. With this caution in mind, let’s look more deeply into the eco-
nomics of discrimination.
taste-for-
discrimina-
tion model A Taste-for-Discrimination Model
theory of discrimi- The taste-for-discrimination model examines prejudice by using the emotion-free
nation that views it
as a preference for
language of demand theory. It views discrimination as resulting from a preference
which an employer or taste for which the discriminator is willing to pay. The model assumes that, for
is willing to pay. whatever reason, prejudiced people experience a subjective or psychic cost—a
 chapter fifteen • wage determination, discrimination, and immigration 401

FIGURE 15-10 DISCRIMINATION AND PRODUCTION POSSIBILITIES

Discrimination repre-
sents a failure to
achieve productive
efficiency. The cost
of discrimination to
society is the sacri-
ficed output associ-

Capital goods
ated with a point
such as D inside the
nation’s production
possibilities curve,
X
compared with points
such as X, Y, and Z
on the curve. Y
D
Kd Z

0 Cd
Consumer goods

disutility—whenever they must interact with those they are biased against. Conse-
quently, they are willing to pay a certain price to avoid interactions with the non-
preferred group. The size of this price depends directly on the degree of prejudice.
The taste-for-discrimination model is general since it can be applied to race, gen-
der, age, and religion, but our discussion focuses on employer discrimination, in
which employers discriminate against nonpreferred workers. For concreteness, we
will look at a white employer discriminating against visible-minority workers.

DISCRIMINATION COEFFICIENT
A prejudiced white employer behaves as if employing visible-minority workers
discrimina- would add a cost. The amount of this cost—this disutility—is reflected in a dis-
tion co- crimination coefficient, d, measured in monetary units. Because the employer is not
efficient prejudiced against whites, the cost of employing a white worker is the white wage
A measure of the
cost or disutility of
rate, Ww. However, the employer’s perceived cost of employing a visible-minority
prejudice. worker is the visible-minority worker’s wage rate, Wb, plus the cost d involved in the
employer’s prejudice, or Wb + d.
The prejudiced white employer will have no preference between visible-minority
and white workers when the total cost per worker is the same, that is, when Ww = Wb
+ d. Suppose the market wage rate for whites is $10 and the monetary value of the
disutility the employer attaches to hiring visible minorities is $2 (that is, d = $2). This
employer will be indifferent between hiring visible minorities and whites only
when the visible-minority wage rate is $8, since at this wage the perceived cost of
hiring either a white or a visible-minority worker is $10: $10 white wage = $8 visible-
minority wage + $2 discrimination coefficient.
It follows that our prejudiced white employer will hire visible minorities only if their wage
rate is sufficiently below that of whites. By “sufficiently” we mean at least the amount
of the discrimination coefficient.
402 Part Three • Microeconomics of Resource Markets

The greater a white employer’s taste for discrimination as reflected in the value
of d, the larger the difference between white wages and the lower wages at which
visible minorities will be hired. A colour-blind employer whose d is $0 will hire
equally productive visible minorities and whites impartially if their wages are the
same. A blatantly prejudiced white employer whose d is infinity would refuse to hire
visible minorities even if the visible minority wage were zero.
Most prejudiced white employers will not refuse to hire visible minorities under
all conditions. They will, in fact, prefer to hire visible minorities if the actual white–
visible minority wage difference in the market exceeds the value of d. In our exam-
ple, if whites can be hired at $10 and equally productive visible minorities at only
$7.50, the biased white employer will hire visible minorities. That employer is will-
ing to pay a wage difference of up to $2 per hour for whites to satisfy his or her bias,
but no more. At the $2.50 actual difference, the employer will hire visible minorities.
Conversely, if whites can be hired at $10 and visible minorities at $8.50, whites
will be hired. Again, the biased employer is willing to pay a wage difference of up
to $2 for whites; a $1.50 actual difference means that hiring whites is a “bargain” for
this employer.

PREJUDICE AND THE MARKET VISIBLE MINORITY–WHITE WAGE RATIO

For a particular supply of visible-minority workers, the actual visible minority–
white wage ratio—the ratio determined in the labour market—will depend on the
collective prejudice of white employers. To see why, consider Figure 15-11, which
shows a labour market for visible-minority workers. Initially, suppose the relevant
labour demand curve is D1, so the equilibrium visible-minority wage is $8 and the
equilibrium level of visible-minority employment is 16 million. If we assume that
the white wage (not shown) is $10, then the initial visible minority–white wage ratio
is .80 (= $8/$10).

FIGURE 15-11 THE VISIBLE-MINORITY WAGE AND EMPLOYMENT

LEVEL IN THE TASTE-FOR-DISCRIMINATION MODEL
An increase in prejudice by white
employers as reflected in higher
Visible minority wage rate (dollars)

discrimination coefficients would S

decrease the demand for visible-
minority workers, here from D1 to D2,
and reduce the visible-minority wage
rate and level of visible-minority
employment. This drop in the visible- $9
minority wage rate would lower the
8
visible minority–white wage ratio (not
shown). In contrast, if prejudice were
reduced such that the discrimination 6
coefficients of employers declined,
the demand for visible-minority labour
would increase, as from D1 to D3,
boosting the visible-minority wage D3
D1
rate and level of employment. The D2
higher visible-minority wage rate
would increase the visible 0 2 6 8
minority–white wage ratio. Visible minority employment (millions)
 chapter fifteen • wage determination, discrimination, and immigration 403

Now assume that prejudice against visible-minority workers increases—that is,

the collective d of white employers rises. An increase in d means an increase in the
perceived cost of visible-minority labour at each visible-minority wage rate, and
that reduces the demand for visible-minority labour, say, from D1 to D2. The visible-
minority wage rate falls from $8 to $6 in the market, and the level of visible-
minority employment declines from six million to two million. The increase in white
employer prejudice reduces the visible-minority wage rate and thus the actual vis-
ible minority–white wage ratio. If the white wage rate remains at $10, the new vis-
ible minority–white ratio is .6 (= $6/$10).
Conversely, suppose social attitudes change such that white employers become
less biased and their discrimination coefficient as a group declines. This change
decreases the perceived cost of visible-minority labour at each visible-minority
wage rate, so the demand for visible-minority labour increases, as from D1 to D3. In
this case, the visible-minority wage rate rises to $9, and employment of visible-
minority workers increases to eight million. The decrease in white employer preju-
dice increases the visible-minority wage rate and thus the actual visible minority–
white wage ratio. If the white wage remains at $10, the new visible minority–white
wage ratio is .9 (= $9/$10).

COMPETITION AND DISCRIMINATION

The taste-for-discrimination model suggests that competition will reduce discrimi-
nation in the very long run, as follows: The actual visible minority–white wage dif-
ference for equally productive workers—say, $2—allows nondiscriminators to hire
visible minorities for less than whites. Firms that hire visible-minority workers will,
therefore, have lower actual wage costs per unit of output and lower average total
costs than will the firms that discriminate. These lower costs will allow non-
discriminators to underprice discriminating competitors, eventually driving them
out of the market.
Critics of this implication of the taste-for-discrimination model note that progress
in eliminating racial discrimination has been modest. Discrimination based on race
has persisted in Canada and other market economies decade after decade. To
explain why, economists have proposed other models. (Key Question 12)

Statistical Discrimination
statistical A second theory of discrimination centres on the concept of statistical discrimina-
discrimina- tion, in which people are judged based on the average characteristics of the group to which
tion Judging they belong, rather than on their own personal characteristics or productivity. The unique-
individuals on the
average characteris-
ness of this theory is its suggestion that discriminatory outcomes are possible even
tic of the group to where no prejudice exists.
which they belong
rather than on BASIC IDEA
their own personal
characteristics. Suppose you are given a complex, but solvable, mathematical problem and told you
will get $1 million in cash if you can identify a student on campus who is capable
of solving it. The catch is that you have only 15 minutes, are restricted to the cam-
pus area, and must approach students one at a time. Who among the thousands of
students—all strangers—would you approach first? Obviously, you would prefer to
choose a mathematics, physics, or engineering major. Would you choose a man or a
woman? A white or a member of a visible minority? If gender or race plays any role
in your choice, you are engaging in statistical discrimination.
404 Part Three • Microeconomics of Resource Markets

LABOUR MARKET EXAMPLE

How does statistical discrimination show itself in labour markets? Employers with
job openings want to hire the most productive workers available. They have their
personnel department collect information concerning each job applicant, including
age, education, and work experience. They may supplement that information with
preemployment tests, which they feel are helpful indicators of potential job per-
formance. But it is very expensive to collect detailed information about job applicants,
and it is difficult to predict job performance based on limited data. Consequently,
some employers looking for inexpensive information many consider the average
characteristics of women and minorities in determining whom to hire. They are
practising statistical discrimination when they do so. They are using gender, race,
or ethnic background as a crude indicator of production-related attributes.
For example, suppose an employer who plans to invest heavily in training a
worker knows that on average women are less likely to be career-oriented than men,
more likely to quit work to care for young children, and more likely to refuse geo-
graphical transfers. Thus, on average, the return on the employer’s investment in
training is likely to be less when choosing a woman than when choosing a man. All
else equal, when choosing between two job applicants, one a woman and the other
a man, this employer is likely to hire the man.
Note what is happening here. Average characteristics for a group are being
applied to individual members of that group. The employer is falsely assuming that
each and every woman worker has the same employment tendencies as the average
woman. Such stereotyping means that numerous women who are career-oriented,
who plan to work after having children, or who don’t plan to have children, and
who are flexible as to geographical transfers will be discriminated against.

PROFITABLE, UNDESIRABLE, BUT NOT MALICIOUS

The firm that practises statistical discrimination is not being malicious in its hiring
behaviour (although it may be violating antidiscrimination laws). The decisions it
makes will be rational and profitable, because on average its hiring decisions are
likely to be correct. Nevertheless, many people suffer because of statistical discrim-
ination, since it blocks the economic betterment of capable people. Since it is prof-
itable, statistical discrimination tends to persist.

Occupational Segregation: The Crowding Model

occupa- The practice of occupational segregation—the crowding of women, visible minorities,
tional and certain ethnic groups into less desirable, lower-paying occupations—is still apparent in
segregation the Canadian economy. Statistics indicate that women are disproportionately concen-
The crowding of
women or minori- trated in a limited number of occupations such as teaching, nursing, and secretarial
ties into less desir- and clerical jobs. Visible minorities are crowded into low-paying jobs such as those
able, lower-paying of laundry workers, cleaners and household aides, hospital orderlies, agricultural
occupations. workers, and other manual labourers.
Let’s look at a model of occupational segregation, using women and men as an
example.

THE MODEL
The character and income consequences of occupational discrimination are revealed
through a labour supply and demand model. We make the following assumptions:
● The labour force is equally divided between male and female workers. Let’s
say there are six million male and six million female workers.
 chapter fifteen • wage determination, discrimination, and immigration 405

● The economy comprises three occupations, X, Y, and Z, with identical labour

demand curves, as shown in Figure 15-12.
● Men and women have the same labour force characteristics; each of the three
occupations could be filled equally well by men or by women.

EFFECTS OF CROWDING
Suppose that, as a consequence of discrimination, the six million women are
excluded from occupations X and Y and crowded into occupation Z, where they
earn wage W. The men distribute themselves equally among occupations X and Y,
meaning that three million male workers are in each occupation and have a common
wage of M. (If we assume that there are no barriers to mobility between X and Y,
any initially different distribution of males between X and Y would result in a wage
differential between the two occupations. That differential would prompt labour
shifts from the low-wage to the high-wage occupation until an equal distribution
occurred.)
Because women are crowded into occupation Z, labour supply (not shown) is
larger and their wage rate W is much lower than M. Because of the discrimination,
this is an equilibrium situation that will persist as long as the crowding occurs. The
occupational barrier means women cannot move into occupations X and Y in pur-
suit of a higher wage.
The result is a loss of output for society. To see why, recall again that labour
demand reflects labour’s marginal revenue product, which is labour’s contribution
to domestic output. Thus, the grey areas for occupations X and Y in Figure 15-12
show the decrease in domestic output—the market value of the marginal output—
caused by subtracting one million women from each of these occupations. Similarly,
the orange area for occupation Z shows the increase in domestic output caused by
moving two million women into occupation Z. Although society would gain the
added output represented by the orange area in occupation Z, it would lose the out-
put represented by the sum of the two grey areas in occupations X and Y. That out-
put loss exceeds the output gain, producing a net output loss for society.

FIGURE 15-12 THE ECONOMICS OF OCCUPATIONAL SEGREGATION

M M
Wage rate
Wage rate

Wage rate

B
B B

W
Dx Dy Dz

0 3 4 0 3 4 0 4 6
Quantity of labour (millions) Quantity of labour (millions) Quantity of labour (millions)
(a) Occupation X (b) Occupation Y (c) Occupation Z
By crowding women into one occupation, men enjoy high wage rates of M in occupations X and Y, while women receive low
wages of W in occupation Z. The elimination of discrimination will equalize wage rates at B and result in a net increase in the
nation’s output.
406 Part Three • Microeconomics of Resource Markets

ELIMINATING OCCUPATIONAL SEGREGATION

Now assume that through legislation or sweeping changes in social attitudes, dis-
crimination disappears. Women, attracted by higher wage rates, shift from occupa-
tion Z to X and Y; one million women move into X and another one million move
into Y. Now there are four million workers in Z and occupational segregation is
eliminated. At that point there are four million workers in each occupation, and
wage rates in all three occupations are equal, here at B. That wage equality elimi-
nates the incentive for further reallocations of labour.
The new, nondiscriminatory equilibrium clearly benefits women, who now
receive higher wages; it hurts men, who now receive lower wages. But women were
initially harmed and men benefited through discrimination; removing discrimina-
tion corrects that situation.
Society also gains. The elimination of occupational segregation reverses the net
output loss just discussed. Adding one million women to each of occupations X and
Y in Figure 15-12 increases domestic output by the sum of the two grey areas. The
decrease in domestic output caused by losing two million women from occupation
Z is shown by the orange area. The sum of the two increases in domestic output in
X and Y exceeds the decrease in domestic output in Z. With end of the discrimina-
tion, two million women workers have moved from occupation Z, where their con-
tribution to domestic output (their MRP) is low, to higher paying occupations X and
Y, where their contribution to domestic output is high. Thus society gains a more
efficient allocation of resources from the removal of occupational discrimination. (In
terms of Figure 15-10, society moves from a point inside its production possibilities
curve to a point closer to, or on, the curve.)
For example, suppose the easing of occupational barriers has led to a surge of
women gaining advanced degrees in some high-paying professions. In recent years, for
instance, the percentage of law degrees and medical degrees awarded to women has
exceeded 40 percent, compared with less than 10 percent in 1970. (Key Question 14)

● Discrimination reduces domestic output and
occurs when workers who have the same abili-
ties, education, training, and experience as
other workers receive inferior treatment with
respect to hiring, occupational access, promo-
tion, or wages.
● Nondiscriminatory factors explain about one-
half of the gender and racial earnings gap;
most of the remaining gap is thought to reflect
discrimination.
● The taste-for-discrimination model sees dis-
crimination as representing a preference or
taste for which the discriminator is willing
to pay.
● The theory of statistical discrimination says that
employers often wrongly judge individuals
based on average group characteristics rather
than on personal characteristics, thus harming
those discriminated against.
● The crowding model of discrimination suggests
that when women and minorities are systemat-
ically excluded from high-paying occupations
and crowded into low-paying ones, their wages
and society’s domestic output are reduced.

Antidiscrimination Policies and Issues

The government has several ways of dealing with discrimination. One indirect pol-
The Role of
Governments icy is to promote a strong, growing economy. An expanding demand for products
 chapter fifteen • wage determination, discrimination, and immigration 407

increases the demand for all workers. When the economy is at or near full employ-
ment, prejudiced employers must pay increasingly higher wages to entice preferred
workers away from other employers. Many, perhaps most, such employers are
likely to decide that their taste for discrimination is not worth the cost. Tight labour
markets also help overcome stereotyping. Once women and minorities obtain good
jobs in tight labour markets, they have an opportunity to show that they can do the
work as well as white males.
A second indirect antidiscrimination policy is to improve the education and train-
ing opportunities of women and minorities. For example, upgrading the quantity
and quality of schooling received by visible minorities will make them more com-
petitive with whites for higher-paying positions.
The third way of reducing discrimination is through direct governmental inter-
vention. The federal and provincial governments have outlawed certain practices in
hiring, promotion, and compensation and have required that government contrac-
tors take action to ensure that women and minorities are hired at least up to their
proportions of the labour force.

The Employment Equity Controversy

employment Employment equity consists of special efforts by employers to increase employ-
equity Policies ment and promotion opportunities for groups that have suffered past discrimina-
and programs that tion and that continue to experience discrimination. To say that employment equity
establish targets of
increased employ-
has stirred controversy is to make an understatement. Strong arguments are made
ment and promo- for and against this approach to remedying discrimination.
tion for women
and minorities. IN SUPPORT OF EMPLOYMENT EQUITY
Those who support employment equity say that historically women and minorities
have been forced to carry the extra burden of discrimination in their attempts to
achieve economic success. Thus, they find themselves far behind white males, who
have been preferred workers. Merely removing the discrimination burden does
nothing to close the present socioeconomic gap. Aggressive action to hire women
and minorities, not just to provide equal opportunity, is necessary to counter the
inherent bias in favour of white men if women and minorities are to catch up.
Supporters of employment equity argue that job discrimination is so pervasive
that it will persist for decades if society is content to accept only marginal anti-
discriminatory changes in employment practices. Moreover, such changes are ham-
pered by the fact that white males have achieved on-the-job seniority, which
protects them from layoffs and places the burden of unemployment disproportion-
ately on women and minorities. And women and minorities have been discrimi-
<www.web.net/~allforee/
empeqity.htm>
nated against in acquiring human capital: the education and job training needed to
Employment equity: compete on equal terms with white males. Discrimination has supposedly become
Facts and myths so highly institutionalized that extraordinary countermeasures are required.
Those who accept this line of reasoning endorse employment equity and even pref-
erential treatment as appropriate means for hastening the elimination of discrimina-
tion. In this view, employment equity is not only a path toward social equity but also
a good national strategy for enhancing efficiency and economic growth since it brings
formerly excluded groups directly into the productive economic mainstream.

OPPOSING VIEW
Those who oppose employment equity claim that it often goes beyond aggressive
recruitment to become preferential treatment. In this view, employment equity has
408 Part Three • Microeconomics of Resource Markets

often prodded employers to hire less-qualified women and less-qualified visible-

minority workers, impairing economic efficiency. They also insist that preferential
reverse dis- treatment is simply reverse discrimination. Preferential treatment and discrimina-
crimination tion, they say, are simply two views of the same thing: to show preference for A is
The view that the to discriminate against B.
preferential treat-
ment associated
Some opponents of employment equity go further, contending that policies that
with employment give preferential treatment to disadvantaged groups have actually worked to the
equity constitutes long-term detriment of those groups. Such policies, they say, have placed many per-
discrimination sons in positions where their relative skill deficiencies become evident to their
against other employers and coworkers. That has had two effects, both negative: First, majority
groups.
workers who have been passed over for jobs or promotions resent those who are
given special treatment. Second, others may mistakenly stereotype the highly qual-
ified women and visible-minority members of the workforce who have no need of
preferential treatment as “employment equity hires.” In this highly controversial
view, continuing racial tension not only reflects the long legacy of discrimination
but also several ill-conceived employment equity policies designed to end it.

Immigration
Immigration has long been controversial in Canada, and views on the subject are
often tied to discrimination. Should more or fewer people be allowed to migrate to
the Canada? How should the problem of illegal entrants be handled?

Number of Immigrants
legal The annual flow of legal immigrants (who have permission to reside in Canada)
immigrants was roughly 150,000 from the 1950s to the 1980s. In the 1990s, the number of immi-
People who lawfully grants averaged more than 200,000 per year. About one-third of recent annual pop-
enter a country and
live there.
ulation growth in Canada is the result of immigration. (Global Perspective 15.2
shows the countries of origin of Canada’s legal immigrants in 1998.)
illegal Such data are imperfect, however, because they do not include illegal immi-
immigrants grants, those who arrive without permission.
People who enter a
country unlawfully
and live there. Economics of Immigration
Figure 15-13 provides some insight into the economic effects of immigration. In Fig-
ure 15-13(a), Du is the demand for labour in Canada; in Figure 15-13(b), Dm is the
demand for labour in Mexico. The demand for labour is greater in Canada, pre-
sumably because the nation has more capital and more advanced technologies that
enhance the productivity of labour. (Recall from Chapter 14 that the labour demand
curve is based on the marginal revenue productivity of labour.) Conversely, since
machinery and equipment are presumably scarce in Mexico and technology less
sophisticated, labour demand there is weak. We also assume that the before-
migration labour forces of Canada and Mexico are c and C, respectively, and that
both countries are at full employment.

WAGE RATES AND WORLD OUTPUT

If we further assume that migration (1) has no cost, (2) occurs solely in response
to wage differentials, and (3) is unimpeded by law in either country, then workers
will migrate from Mexico to Canada until wage rates in the two countries are equal
at We. At that level, CF (equals cf) workers will have migrated from Mexico to
 chapter fifteen • wage determination, discrimination, and immigration 409

15.2

Thousands of Immigrants
Canada’s immigrants 0 5 10 15 20 25
by country of origin
Hong Kong
Almost half the 216,000 legal India
immigrants who came to China
Canada in 1997 originated in Taiwan
the 7 countries shown here. Pakistan
Philippines
Iran

Source: Citizenship and Immigration Canada, <www.cic.gc.ca/English/pub/facts97e/1g.html>

Canada. Although the Canadian wage level will fall from Wu to We , domestic out-
put (the sum of the marginal revenue products of the entire workforce) will increase
from 0abc to 0adf. In Mexico, the wage rate will rise from Wm to We , but domestic out-
put will decline there from 0ABC to 0ADF. Because the gain in domestic output
cbdf in Canada exceeds the output loss FDBC in Mexico, the world’s output has
increased.
We can conclude that the elimination of barriers to the international flow of
labour tends to increase worldwide economic efficiency. The world gains because
the freedom to migrate enables people to move to countries where they can
make larger contributions to world production. Migration involves an efficiency
gain. It enables the world to produce a larger real output with a given amount
of resources.

FIGURE 15-13 THE SIMPLE ECONOMICS OF IMMIGRATION

The migration of labour
a
to high-income Canada
(panel a) from low-
income Mexico (panel b) A
increases Canadian
Wage rate

Wage rate

domestic output, b
reduces the average Wu
d D
level of Canadian wages, We We
and increases Canadian B
business income while Wm
having the opposite
Du Dm
effects in Mexico. The
Canadian domestic out-
put gain of cbdf exceeds 0 c f 0 F C
Mexico’s domestic out-
put loss of FDBC; thus
the migration yields a net Quantity of labour (millions) Quantity of labour
increase in world output. (millions)
(a) Canada (b) Mexico
410 Part Three • Microeconomics of Resource Markets

INCOME SHARES
Our model also suggests that the flow of immigrants will enhance business income
(or capitalist income) in Canada and reduce it in Mexico. As just noted, before-immi-
gration domestic output in Canada is represented by area 0abc. The total wage bill
is 0Wu bc—the wage rate multiplied by the number of workers. The remaining tri-
angular area Wu ab represents business income before immigration. The same rea-
soning applies to Mexico, where Wm AB is before-immigration business income.
Unimpeded immigration increases business income from Wu ab to We ad in Canada
and reduces it from Wm AB to We AD in Mexico. Canadian businesses benefit from
immigration; Mexican businesses are hurt by emigration. This result is what we
would expect intuitively; Canada is gaining “cheap” labour, and Mexico is losing
“cheap” labour. This conclusion is consistent with the historical fact that Canadian
employers have often actively recruited immigrants.

Complications and Modifications

Our model includes some simplifying assumptions and overlooks a relevant factor.
We now relax some of the assumptions and introduce the omitted factor to see how
our conclusions are affected.

COSTS OF MIGRATION
We assumed that international movement of workers is without personal cost, but
obviously it is not. Both explicit, out-of-pocket costs of physically moving workers and
their possessions and the implicit opportunity cost of lost income while the workers
are moving and becoming established in the new country exist. Still more subtle costs
are involved in adapting to a new culture, language, climate, and so forth. All such
costs must be estimated by the potential immigrants and weighed against the expected
benefits of higher wages in the new country. People who estimate that benefits exceed
costs will migrate; people who see costs as exceeding benefits will stay put.
In terms of Figure 15-13, the existence of migration costs means that the flow of
labour from Mexico to Canada will stop short of that needed to close the wage dif-
ferential entirely. Wages will remain somewhat higher in Canada than in Mexico; the
wage difference will not cause further migration and close up the wage gap because
the marginal benefit of the higher wage does not cover the marginal cost of migra-
tion. Thus, the world production gain from migration will be reduced since wages
will not equalize.

REMITTANCES AND BACKFLOWS

Most migration is permanent; workers who acquire skills in the receiving country
tend not to return home. However, some migrants view their moves as temporary.
They move to a more highly developed country, accumulate some wealth or edu-
cation through hard work and frugality, and return home to establish their own
enterprises. During their time in the new country, migrants frequently make sizable
remittances to their families at home, which cause a redistribution of the net gain
from migration between the countries involved. In Figure 15-13, remittances by
Mexican workers in Canada to their relatives in Mexico would cause the gain in
Canadian domestic output to be less than shown and the loss to Mexican domestic
output also to be less than shown.
Actual backflows—the return of migrants to their home country—might also
alter gains and losses through time. For example, if some Mexican workers who
migrated to Canada acquired substantial labour market or managerial skills and
 chapter fifteen • wage determination, discrimination, and immigration 411

then returned home, their enhanced human capital might make a substantial con-
tribution to economic development in Mexico.

FULL EMPLOYMENT VERSUS UNEMPLOYMENT

Our model assumes full employment in the sending and receiving countries. Mex-
ican workers presumably leave low-paying jobs to take (more or less immediately)
higher-paying jobs in Canada. However, in many cases the factor that “pushes”
immigrants from their homelands is not low wages but chronic unemployment and
underemployment. Many developing countries are overpopulated and have sur-
plus labour; workers are either unemployed or so grossly underemployed that their
marginal revenue product is zero.
If we allow for this possibility, then Mexico actually gains (not loses) by having
such workers emigrate. The unemployed workers are making no contribution to
Mexico’s domestic output and must be sustained by transfers from the rest of the
labour force. The remaining Mexican labour force will be better off by the amount
of the transfers after the unemployed workers have migrated to Canada. Con-
versely, if the Mexican immigrant workers are unable to find jobs in Canada and are
sustained through transfers from employed Canadian workers, then the after-tax
income of working Canadians will decline. (Key Question 17)

Immigration: Two Views

The traditional perception of immigration is that it consists of young, ambitious
workers seeking opportunity in Canada. They are destined for success because of the
courage and determination they exhibit in leaving their cultural roots to improve
their lives. These energetic workers increase the supply of goods and services with
their labour and simultaneously increase the demand for goods and services with
their incomes and spending. In short, immigration is an engine of economic progress.
The counterview is that immigration is a socioeconomic drag on the receiving
country. Immigrants compete with domestic workers for scarce jobs, pull down the
average level of real wages, and burden the Canadian welfare system.
Both these views are far too simplistic. Immigration can either benefit or harm the
receiving nation, depending on the number of immigrants; their education, skills,
and work ethic; and the rate at which they can be absorbed into the economy with-
out disruption. From a strictly economic perspective, nations seeking to maximize
net benefits from immigration should expand immigration until its marginal bene-
fits equal its marginal costs. The MB = MC conceptual framework explicitly recog-
nizes that there can be too few immigrants, just as there can be too many. Moreover,
the framework recognizes that from a strictly economic standpoint, not all immi-
grants are alike. The immigration of, say, a highly educated scientist has a different
effect on the economy than does the immigration of a long-term welfare recipient.

● All else equal, immigration reduces wages, ● Assessing the effects of immigration is compli-
increases domestic output, and increases busi- cated by such factors as unemployment, back-
ness income in the receiving nation; it has the flows and remittances, and fiscal impacts.
opposite effects in the sending nation.
412 Part Three • Microeconomics of Resource Markets
There have long been allega-
tions of discrimination against
women in the hiring process in
some occupations, but such dis-
crimination is usually difficult to
demonstrate. Economists Clau-
dia Goldin and Cecilia Rouse
spotted a unique opportunity for
testing such discrimination as it
relates to major symphony or-
chestras. In the past, orchestras
relied on their musical directors
to extend invitations to candi-
dates, audition them, and hand-
pick new members. Concerned
with the potential for hiring bias,
in the 1970s and 1980s orches-
tras altered the process in two
ways. First, orchestra members
were included as judges, and,
second, orchestras began open
competitions using blind audi-
tions with a physical screen
(usually a room divider) to con-
ceal the identity of the candi-
dates. (These blind auditions,
however, did not extend to the
final competition in most or-
chestras.) Did the change in pro-
cedures increase the probability
of women being hired?
To answer this question,
Goldin and Rouse studied the or-
chestral management files of au-
ditions for eight major orches-
tras. These records contained the
names of all candidates and iden-
tified those who had advanced to
the next round, including the ulti-
mate winners of the competition.
ORCHESTRATING IMPARTIALITY
Have “blind” musical auditions, in which screens are
used to hide the identity of candidates, affected the
success of women in obtaining positions in major
symphony orchestras?
The researchers then looked for
women in the sample who had
competed in auditions both be-
fore and after the introduction of
the blind screening.
A strong suspicion existed of
bias against women in hiring
musicians for the nation’s finest
orchestras. These positions are
highly desirous, not only be-
cause they are prestigious but
also because they offer high pay
(often more than $75,000 annu-
ally). In 1970 only 5 percent of
the members of the top five
orchestras were women, and
many music directors publicly
suggested that women players,
in general, have less musical
talent.
The change to screens pro-
vided direct evidence of past
discrimination. The screens in-
creased by 50 percent the proba-
bility that a woman would be
advanced from the preliminary
rounds. The screens also greatly
increased the likelihood that a
woman would be selected in the
final round. Without the screens
about 10 percent of all hires
were women, but with the
screens about 35 percent were
women. Today, about 25 percent
of the membership of top sym-
phony orchestras are women.
The screens explain from 25 to
45 percent of the increases in
the proportion of women in the
orchestras studied.
Was the past discrimination
in hiring an example of statisti-
cal discrimination based on, say,
a presumption of greater turn-
over by women or more leaves
for medical (including maternity)
or other reasons? To answer that
question, Goldin and Rouse ex-
amined information on turnover
and leaves of orchestra mem-
bers between 1960 and 1996.
They found that neither differed
by gender, so leaves and turn-
over should not have influenced
hiring decisions.
Instead, the discrimination in
hiring seemed to reflect a taste
for discrimination by musical di-
rectors. Male musical directors
apparently had a positive dis-
crimination coefficient d. At the
fixed (union-determined) wage,
they simply preferred male mu-
sicians, at women’s expense.
Source: Claudia Goldin and Cecilia
Rouse, “Orchestrating Impartiality:
The Impact of ‘Blind’ Auditions on
Female Musicians,” American Eco-
nomic Review, September 2000, pp.
715–741.
 chapter fifteen • wage determination, discrimination, and immigration
chapter summary
1. The term “labour” encompasses all people
who work for pay. The wage rate is the price
paid per unit of time for labour. Labour earn-
ings comprise total pay and are found by
multiplying the number of hours worked by
the hourly wage rate. The nominal wage rate
is the amount of money received per unit of
time; the real wage rate is the purchasing
power of the nominal wage.
2. The long-run growth of real hourly earnings
—the average real wage—roughly matches
that of productivity, with both increasing
over the long run.
3. Global comparisons suggest that real wages
in Canada are relatively high, but not the
highest, internationally. High real wages in
the advanced industrial countries stem
largely from high labour productivity.
4. Specific wage rates depend on the structure
of the particular labour market. In a compet-
itive labour market, the equilibrium wage
rate and level of employment are deter-
mined at the intersection of the labour sup-
ply curve and labour demand curve. For the
individual firm, the market wage rate estab-
lishes a horizontal labour supply curve,
meaning that the wage rate equals the firm’s
constant marginal resource cost. The firm
hires workers to the point where its MRP
equals this MRC.
5. Under monopsony the marginal resource
cost curve lies above the resource supply
curve because the monopsonist must bid up
the wage rate to hire extra workers and must
pay that higher wage rate to all workers. The
monopsonist hires fewer workers than are
hired under competitive conditions, pays
less-than-competitive wage rates (has lower
labour costs), and thus obtains greater profit.
6. A union may raise competitive wage rates
by (a) increasing the derived demand for
labour, (b) restricting the supply of labour
through exclusive unionism, or (c) directly
enforcing an above-equilibrium wage rate
through inclusive unionism.
7. In many industries the labour market takes
the form of bilateral monopoly, in which a
strong union sells labour to a monopsonistic
employer. The wage-rate outcome of this
labour market model depends on union and
employer bargaining power.
413
8. On average, unionized workers realize wage
rates 10 to 15 percent higher than compara-
ble nonunion workers.
9. Economists disagree about the desirability
of the minimum wage as an antipoverty
mechanism. While it causes unemployment
for some low-income workers, it raises the
incomes of those who retain their jobs.
10. Wage differentials are largely explainable in
terms of (a) marginal revenue productivity of
various groups of workers; (b) noncompet-
ing groups arising from differences in the
capacities and education of different groups
of workers; (c) compensating wage differ-
ences, that is, wage differences that must be
paid to offset nonmonetary differences in
jobs; and (d) market imperfections in the
form of lack of job information, geographical
immobility, union and government restraints,
and discrimination.
11. The principal–agent problem arises when
workers provide less-than-expected effort.
Firms may combat this by monitoring work-
ers, by creating incentive pay schemes that
link worker compensation to effort, or by
paying efficiency wages.
12. Discrimination relating to the labour market
occurs when women or minorities having
the same abilities, education, training, and
experience as men or white workers receive
inferior treatment with respect to hiring,
occupational choice, education and training,
promotion, and wage rates. Forms of dis-
crimination include wage discrimination,
employment discrimination, occupational
discrimination, and human capital discrimi-
nation. Discrimination redistributes national
income and, by creating inefficiencies,
diminishes its size.
13. In the taste-for-discrimination model, some
white employers have a preference for dis-
crimination, measured by a discrimination
coefficient d. Prejudiced white employers
will hire visible-minority workers only if their
wages are at least d dollars below those of
whites. The model indicates that declines
in the discrimination coefficients of white
employers will increase the demand for
visible-minority workers, raising the visible-
minority wage rate and the ratio of visible-
minority wages to white wages. It also
414 Part Three • Microeconomics of Resource Markets

suggests that competition may eliminate dis-
crimination in the long run.
14. Statistical discrimination occurs when em-
ployers base employment decisions about
individuals on the average characteristics of
groups of workers. That practice can lead to
discrimination against individuals even in
the absence of prejudice.
15. The crowding model of occupational seg-
regation indicates how white males gain
higher earnings at the expense of women
and minorities who are confined to a limited
number of occupations. The model shows
that discrimination also causes a net loss of
domestic output.
16. Government antidiscrimination legislation
and policies involve direct governmental
intervention, including the requirement that
these firms enact employment equity pro-
grams to benefit women and certain minor-
ity groups.
17. Those who support employment equity
say it is needed to help compensate women
and minorities for decades of discrimi-
nation. Opponents say employment equity
causes economic inefficiency and reverse
discrimination.
18. Supply and demand analysis suggests that
the movement of migrants from a poor
country to a rich country (a) increases domes-
tic output in the rich country, (b) reduces the
average wage in the rich country, and (c) in-
creases business income in the rich country.
The opposite effects occur in the poor coun-
try, but the world as a whole realizes a larger
total output.
19. The outcomes of immigration predicted by
simple supply and demand analysis become
more complicated on consideration of (a) the
costs of moving, (b) the possibility of remit-
tances and backflows, (c) the level of unem-
ployment in each country, and (d) the fiscal
impact on the taxpayers of each country.

terms and concepts

nominal wage, p. 376
real wage, p. 376
purely competitive labour
market, p. 379
monopsony, p. 382
exclusive unionism, p. 387
occupational licensing, p. 388
inclusive unionism, p. 388
bilateral monopoly, p. 390
minimum wage, p. 391
wage differentials, p. 393
marginal revenue
productivity, p. 393
noncompeting groups, p. 394
investment in human capital,
p. 395
compensating differences,
p. 395
incentive pay plan, p. 397
wage discrimination, p. 399
employment discrimination,
p. 400
occupational discrimination,
p. 400
human capital discrimination,
p. 400
taste-for-discrimination
model, p. 400
discrimination coefficient,
p. 401
statistical discrimination,
p. 403
occupational segregation,
p. 404
employment equity, p. 407
reverse discrimination, p. 408
legal immigrants, p. 408
illegal immigrants, p. 408

study questions
1. Explain why the general level of wages is high
in Canada and other industrially advanced
countries. What is the single most important
factor underlying the long-run increase in
average real-wage rates in Canada?
2. Why is a firm in a purely competitive labour
market a wage-taker? What would happen if
that firm decided to pay less than the going
market wage rate?
3. KEY QUESTION Describe wage deter-
mination in a labour market in which work-
ers are unorganized and many firms actively
compete for the services of labour. Show
this situation graphically, using W 1 to indi-
cate the equilibrium wage rate and Q1 to
show the number of workers hired by the
firms as a group. Show the labour supply
curve of the individual firm and compare it
with that of the total market. Why are there
differences? In the diagram representing the
firm, identify total revenue, total wage cost,
and revenue available for the payment of
nonlabour resources.
 chapter fifteen • wage determination, discrimination, and immigration
4. KEY QUESTION Complete the fol-
lowing labour supply table for a firm hiring
labour competitively:
Total Marginal
Units of Wage labour cost resource
labour rate (wage bill) (labour) cost
0 $14 $______
$______
1 14 ______
______
2 14 ______
______
3 14 ______
______
4 14 ______
______
5 14 ______
______
6 14 ______
a. Show graphically the labour supply and
marginal resource (labour) cost curves
for this firm. Explain the relationship of
these curves to one another.
b. Plot the labour demand data of question
2 in Chapter 14 on the graph used in a.
What are the equilibrium wage rate and
level of employment? Explain.
5. Suppose the formerly competing firms in
question 3 form an employers’ association
that hires labour as a monopsonist would.
Describe verbally the effect on wage rates
and employment. Adjust the graph you drew
for question 3, showing the monopsonistic
wage rate and employment level as W 2
and Q2, respectively. Using this monopsony
model, explain why hospital administrators
sometimes complain about a shortage of
nurses. How might such a shortage be
corrected?
6. KEY QUESTION Assume a firm is a
monopsonist that can hire its first worker for
$6 but must increase the wage rate by $3 to
attract each successive worker. Draw the
firm’s labour supply and marginal labour
cost curves and explain their relationships to
one another. On the same graph, plot the
labour demand data of question 2 in Chapter
14. What are the equilibrium wage rate and
level of employment? Why do these differ
from your answer to question 4?
7. KEY QUESTION Assume a monop-
sonistic employer is paying a wage rate of
Wm and hiring Qm workers, as indicated in
Figure 15-8. Now suppose an industrial
union is formed that forces the employer to
415
accept a wage rate of Wc. Explain verbally
and graphically why in this instance the
higher wage rate will be accompanied by an
increase in the number of workers hired.
8. Have you ever worked for the minimum wage?
If so, for how long? Would you favour increas-
ing the minimum wage by a dollar? by two dol-
lars? by five dollars? Explain your reasoning.
9. “Many of the lowest-paid people in society—
for example, short-order cooks—also have
relatively poor working conditions. Hence,
the notion of compensating wage differen-
tials is disproved.” Do you agree? Explain.
10. What is meant by investment in human cap-
ital? Use this concept to explain (a) wage dif-
ferentials, and (b) the long-run rise of real
wage rates in Canada.
11. What is the principal–agent problem? Have
you ever worked in a setting where this
problem arose? If so, do you think increased
monitoring would have eliminated the prob-
lem? Why don’t firms simply hire more
supervisors to eliminate shirking?
12. KEY QUESTION The labour demand
and supply data in the table below relate to
a single occupation. Use them to answer the
questions that follow. Base your answers on
the taste-for-discrimination model.
Quantity Quantity of visible
of labour Visible minority labour
demanded, minority supplied
thousands wage rate (thousands)
24 $16 52
30 14 44
35 12 35
42 10 28
48 8 20
a. Plot the labour demand and supply
curves for visible minority workers in this
occupation.
b. What are the equilibrium visible minority
wage rate and quantity of visible minority
employment?
c. Suppose the white wage rate in this occu-
pation is $16. What is the visible minority-
to-white wage ratio?
d. Suppose a particular employer has a dis-
crimination coefficient d of $5 per hour.
416 Part Three • Microeconomics of Resource Markets
Will that employer hire visible-minority
or white workers at the visible minority–
white wage ratio indicated in part (c)?
Explain.
e. Suppose employers as a group become
less prejudiced against visible minorities
and demand 14 more units of visible-
minority labour at each visible-minority
wage rate in the table. What are the new
equilibrium visible-minority wage rate
and level of visible-minority employment?
Does the visible minority–white wage
ratio rise or fall? Explain.
f. Suppose visible minorities as a group
increase their labour services in that
occupation, collectively offering 14 more
units of labour at each visible-minority
wage rate. Disregarding the changes
indicated in part (e), what are the new
equilibrium visible-minority wage rate
and level of visible-minority employ-
ment? Does the visible minority–white
wage ratio rise, or does it fall?
13. Males under the age of 25 must pay far
higher auto insurance premiums than fe-
males in this age group. How does this fact
relate to statistical discrimination? Statistical
discrimination implies that discrimination
can persist indefinitely, while the taste-for-
discrimination model suggests that competi-
tion might reduce discrimination in the long
run. Explain the difference.
14. KEY QUESTION Use a demand and
supply model to explain the effect of occupa-
tional segregation or crowding on the relative
wage rates and earnings of men and women.
Who gains and who loses from the elimina-
tion of occupational segregation? Is there a
net gain or a net loss to society? Explain.
15. “Current employment equity programs are
based on the belief that to overcome dis-
internet application question
1. Go to <espn.go.com/golfonline> and select
Tours, Rankings, and Money leaders. What
are the annual earnings to date of the top
10 male golfers on the PGA tour? What are
crimination, we must practise discrimina-
tion. That perverse logic has created a sys-
tem that undermines the fundamental values
it was intended to protect.” Do you agree?
Why or why not?
16. Suppose Ann and Becky are applicants to
your university and that they have identi-
cal admission qualifications. Ann who is a
member of a visible minority, grew up in a
public housing development; Becky, who is
white, grew up in a wealthy suburb. You can
admit only one of the two. Which would you
admit and why? Now suppose that Ann is
white and Becky is a member of a visible
minority, all else being equal. Does that
change your selection? Why or why not?
17. KEY QUESTION Use graphical analy-
sis to show the gains and losses resulting
from the migration of workers from a low-
income country to a high-income country.
Explain how your conclusions are affected
by (a) unemployment, (b) remittances to the
home country, (c) backflows of migrants to
their home country, and (d) the personal
characteristics of the migrants. If the mi-
grants are highly skilled workers, is there
any justification for the sending country to
levy a brain drain tax on emigrants?
18. Evaluate: “If Canada deported, say, 100,000
illegal immigrants, the number of unem-
ployed workers in Canada would decline by
100,000.”
19. If a person favours the free movement of
labour within Canada, is it then inconsis-
tent to also favour restrictions on the inter-
national movement of labour? Why or why
not?
20. (The Last Word) What two types of discrimi-
nation are represented by the discrimination
evidenced in this chapter’s The Last Word?
the earnings of the top 10 female golfers on
the LPGA tour? What are the general differ-
ences in earnings between the male and
female golfers? Can you explain them?
 SIXTEEN

Rent,
Interest,
and Profit

H
ow are land prices and rents estab-

lished and why do they differ? For

example, a hectare of land in the mid-

dle of Toronto or Vancouver can sell for more

IN THIS CHAPTER
Y OU WILL LEARN: than $50 million, while a hectare in Northern

How the price of land Manitoba may fetch no more than $500.
is determined.
• What factors determine interest rates and
How the interest rate
is determined. cause them to change? For example, why
•
were interest rates on Guaranteed Invest-
What economic profit is, and
how profits, along with losses, ment Certificate (GIC) 5.08 percent in Canada
allocates resources among
alternative uses in an economy. in March 2000, but only 3.18 percent in
•
What the share of income March 2001?
going to each of the factors
of production is in Canada.
 418 Part Three • Microeconomics of Resource Markets

What are the sources of profits and losses? Why do profits change over time? For
example, why did Nortel Networks’ revenue jump by 26.5 percent in 1999, whereas
Corel Corporation’s revenue decreased and it lost money during that year?
In Chapter 15 we focused on wages and salaries, which account for 75 percent of
national income in Canada. In this chapter we examine the other resource pay-
ments—rent, interest, and profit—that comprise the remaining 25 percent of
national income. We begin by looking at rent.

Economic Rent
To most people, “rent” means the money they must pay for the use of an apartment
or a room. To the business executive, “rent” is a payment made for the use of a fac-
tory building, machine, or warehouse facility. Such definitions of rent can be con-
fusing and ambiguous, however. Dormitory room rent, for example, may include
other payments as well: interest on money the university borrowed to finance the
<www.theshortrun.com/
classroom/glossary/
dormitory, wages for custodial services, utility payments, and so on.
micro/rent.html> Economists use rent in a much narrower sense. Economic rent is the price paid
Economic rent for the use of land and other natural resources that are completely fixed in total sup-
ply. As you will see, this fixed overall supply distinguishes rental payments from
wage, interest, and profit payments.
economic Let’s examine this idea and some of its implications through supply and demand
rent The price analysis. We first assume that all land is of the same grade or quality, meaning that
paid for the use of each arable (tillable) hectare of land is as productive as every other hectare. We
land and other
natural resources,
assume, too, that all land has a single use, for example, producing wheat. And we
the supply of which suppose that land is rented or leased in a competitive market in which many pro-
is fixed (perfectly ducers are demanding land and many landowners are offering land in the market.
inelastic). In Figure 16-1, curve S represents the supply of arable land available in the econ-
omy as a whole, and curve D2 represents the demand of producers for use of that
land. As with all economic resources, this demand is derived from the demand for
the product being produced. The demand curve for land is downward sloping
because of diminishing returns and because, for producers as a group, product price
must be reduced to sell additional units of output.

FIGURE 16-1 THE DETERMINATION OF LAND RENT

Because the supply S of land
(and other natural resources) is S
perfectly inelastic, demand is
Land rent (dollars)

the sole active determinant of

land rent. An increase in R1
demand from D2 to D1 or a
decrease in demand from D2 to D1
R2
D3 will cause a considerable
change in rent: from R2 to R1 in D2
the first instance and from R2 R3
to R3 in the second. But the
amount of land supplied will D3
a b
remain at L0. If demand is very
weak (D4) relative to supply, 0 L0 Hectares of land
land will be a free good,
commanding no rent. D4
 chapter sixteen • rent, interest, and profit 419

Perfectly Inelastic Supply

The unique feature of our analysis is on the supply side. For all practical purposes
the supply of land is perfectly inelastic (in both the short run and long run), as
reflected in supply curve S. Land has no production cost; it is a “free and nonre-
producible gift of nature.” The economy has only so much land, and that’s that. Of
course, within limits any parcel of land can be made more usable by clearing,
drainage, and irrigation, but these are capital improvements and not changes in the
amount of land itself. Increases in the usability of land affect only a small fraction
of the total amount of land and do not change the basic fact that land and other nat-
ural resources are fixed in supply.

Changes in Demand
Because the supply of land is fixed, demand is the only active determinant of land
rent; supply is passive. And what determines the demand for land? The factors we
discussed in Chapter 14 do: the price of the product produced on the land, the pro-
ductivity of land (which depends in part on the quantity and quality of the
resources with which land is combined), and the prices of the other resources that
are combined with land.
If the demand for land in Figure 16-1 increased from D2 to D1, land rent would rise
from R2 to R1. If the demand for land declined from D2 to D3, land rent would fall
from R2 to R3. In either case, the amount of land supplied would remain the same at
quantity L0. Changes in economic rent have no effect on the amount of land available
since the supply of land cannot be augmented. If the demand for land were only D4,
land rent would be zero. Land would be a free good—a good for which demand is so
weak relative to supply that there is an excess supply of it even if the market price is
zero. In Figure 16-1, we show this excess supply as distance b – a at rent of zero. This
essentially was the situation in the free-land era of Canadian history.
The ideas underlying Figure 16-1 help answer one of our chapter-opening ques-
tions. Land prices and rents are so high along the Las Vegas strip, for example,
because the demand for that land is tremendous; it is capable of producing excep-
tionally high revenue from gambling, lodging, and entertainment. In contrast, the
demand for isolated land in the middle of the desert is highly limited because very
little revenue can be generated from its use. (It is an entirely different matter, of
course, if gold can be mined from the land, as is true of some isolated lands in
Nevada in the United States!)

Land Rent: A Surplus Payment

The perfectly inelastic supply of land must be contrasted with the relatively elastic
supply of capital, such as apartment buildings, machinery, and warehouses. In the
long run, capital is not fixed in total supply. A higher price gives entrepreneurs the
incentive incentive to construct and offer larger quantities of property resources. Conversely,
function
of price The a decline in price induces suppliers to allow existing facilities to depreciate and not
inducement that an be replaced. The supply curves of these nonland resources are upward sloping,
increase in the price meaning that the prices paid to such resources have an incentive function. A high
of a commodity price provides an incentive to offer more of the resource, whereas a low price
gives to sellers to prompts resource suppliers to offer less.
make more of it
available (and Not so with land. Rent serves no incentive function, because the total supply of
conversely for a land is fixed. Whether rent is $10,000, $500, $1, or $0 per hectare, the same amount
decrease in price). of land is available to society for use in production, which is why economists
420 Part Three • Microeconomics of Resource Markets

consider rent a surplus payment not necessary to ensure that land is available to the
economy as a whole.

Application: A Single Tax on Land

If land is a gift of nature, costs nothing to produce, and would be available even
without rental payments, why should rent be paid to those who by historical acci-
dent, by inheritance, or by crook happen to be landowners? Socialists have long
argued that all land rents are unearned incomes. They argue that land should be
nationalized (owned by the state) so that any payments for its use can be used by
the government to further the well-being of the entire population rather than be
used by a landowning minority.

HENRY GEORGE’S PROPOSAL

single-tax In the United States, criticism of rental payments has taken the form of a single-tax
movement A movement, which gained significant support in the late nineteenth century. Spear-
movement spear- headed by Henry George’s provocative book Progress and Poverty (1879), support-
headed by Henry
George in the late
ers of this reform movement held that economic rent could be heavily taxed, or even
nineteenth century taxed away, without diminishing the available supply of land or, therefore, the pro-
to make taxes on ductive potential of the economy as a whole.
rental income the George observed that as the population grew and the geographic frontier closed,
only tax levied by landowners enjoyed larger and larger rents from their land holdings. That increase
government; few
advocates remain.
in rents was the result of a growing demand for a resource whose supply was per-
fectly inelastic. Some landlords were receiving fabulously high incomes, not
through any productive effort, but solely through their owning advantageously
located land. George insisted that these increases in land rent belonged to the econ-
omy; he held that land rents should be heavily taxed and the revenue spent for pub-
lic uses. In seeking popular support for his ideas on land taxation, George proposed
that taxes on rental income be the only tax levied by government.
George’s case for taxing land was based not only on equity or fairness but also
on efficiency. That is, a tax on land is efficient because, unlike virtually every other
tax, it does not alter the use of the resource being taxed. A tax on wages reduces
after-tax wages and may weaken the incentive to work; an individual who decides
to work for a $10 before-tax wage may decide to retire when an income tax reduces
the wage to an after-tax $8. Similarly, a property tax on buildings lowers returns to
investors in such property and might cause some to look for other investments, but
no such reallocations of resources occur when land is taxed. The most profitable use
of land before it is taxed remains the most profitable use after it is taxed. Of course,
a landlord could withdraw land from production when a tax is imposed, but that
would mean no rental income at all. And, some rental income, no matter how small,
is better than none.

CRITICISMS
Very few advocates of a single tax on land remain. Critics of the idea have pointed
out the following:
● Current levels of government spending are such that a land tax alone would
not bring in enough revenue; it is unrealistic to consider it as a single tax.
● Most income payments consist of a mixture of such elements as interest, rent,
wages, and profits. Land is typically improved in some way, and economic
rent cannot be readily disentangled from payments for such improvements.
 chapter sixteen • rent, interest, and profit 421

So, in practice, it would be difficult to determine how much of any specific

income payment actually amounted to economic rent.
● So-called unearned income accrues to many people other than landowners,
especially when the economy is growing. For example, consider the capital
gains income received by someone who, some 20 or 25 years ago, chanced to
purchase (or inherit) stock in a firm that has experienced rapid profit growth.
Is such income more earned than the rental income of the landowner?
● Historically, a piece of land is likely to have changed ownership many times.
Former owners may have been the beneficiaries of past increases in the value
of the land (and in land rent). It would hardly be fair to impose a heavy tax on
current owners who paid the competitive market price for the land.

Productivity Differences and Rent Differences

So far we have assumed that all units of land are of the same grade. That is plainly
not so. Different pieces of land vary greatly in productivity, depending on soil fer-
tility and on such climatic factors as rainfall and temperature. Such factors explain,
for example, why Southern Ontario soil is excellently suited to corn production,
why the Prairies are less well suited, and why Yukon is nearly incapable of corn
production. Such productivity differences are reflected in resource demand and
prices. Competitive bidding by producers will establish a high rent for highly pro-
ductive Southern Ontario land; less productive Prairie land will command a much
lower rent; and Yukon land may command no rent at all.
Location itself may be just as important in explaining differences in land rent.
Other things equal, renters will pay more for a unit of land that is strategically
located with respect to materials, labour, and customers than they will for a unit of
land whose location is remote from these things. For example, enormously high
land prices are paid for major ski resorts and land that has oil under it.
Figure 16-1, viewed from a slightly different perspective, reveals the rent differ-
entials from quality differences in land. Assume, again, that only wheat can be pro-
duced on four grades of land, each of which is available in the fixed amount L0.
When combined with identical amounts of labour, capital, and entrepreneurial tal-
ent, the productivity or, more specifically, the marginal revenue product of each of
the four grades of land is reflected in demand curves D1, D2, D3, and D4. Grade 1 land
is the most productive, as shown by D1, while grade 4 is the least productive, as
shown by D4. The resulting economic rents for grades 1, 2, and 3 land will be R1, R2,
and R3, respectively; the rent differential will mirror the differences in productivity
of the three grades of land. Grade 4 land is so poor in quality that, given its supply
S, farmers won’t pay anything to use it. It will be a free good because it is not suffi-
ciently scarce in relation to the demand for it to command a price or a rent.

Alternative Uses of Land

We have assumed that land has only one use. Actually, we know that land normally
has alternative uses. A hectare of Ontario farmland may be useful for raising not only
corn but also for raising corn, oats, barley, and cattle; or it may be useful for build-
ing a house, or a highway, or as a factory site. In other words, any particular use of
land involves an opportunity cost—the forgone production from the next best use
of the resource. Where there are alternative uses, individual firms must pay rent to
cover those opportunity costs to secure the use of land for their particular purpose.
To the individual firm, rent is a cost of production, just as wages and interest are.
422 Part Three • Microeconomics of Resource Markets

Recall that, as viewed by society, economic rent is not a cost. Society would have
the same amount of land with or without the payment of economic rent. From soci-
ety’s perspective, economic rent is a surplus payment above that needed to gain the
use of a resource. But individual firms do need to pay rent to attract land resources
away from alternative uses. For firms, rental payments are a cost. (Key Question 2)

● Economic rent is the price paid for resources
such as land whose supply is perfectly inelastic.
● Land rent is a surplus payment because land
would be available to society even if this rent
were not paid.
● The surplus nature of land rent served as the
basis for Henry George’s single-tax movement.
● Differential rents allocate land among alterna-
tive uses.

Interest
Interest is the price paid for the use of money. It is the price that borrowers need to pay
lenders for transferring purchasing power from the present to the future. It can be
thought of as the amount of money that must be paid for the use of $1 for one year.
Two points are important to this discussion.
1. Interest is stated as a percentage. Interest is paid in kind; that is, money (inter-
est) is paid for the loan of money. For that reason, interest is typically stated as a
percentage of the amount of money borrowed rather than as a dollar amount. It
is less clumsy to say that interest is “12 percent annually” than to say that inter-
est is “$120 per year per $1000.” Also, stating interest as a percentage makes it
easier to compare the interest paid on loans of different amounts. By expressing
interest as a percentage, we can immediately compare an interest payment of,
say, $432 per year per $2880 with one of $1800 per year per $12,000. Both inter-
est payments are 15 percent per year, which is not obvious from the actual dol-
lar figures. This interest of 15 percent per year is referred to as a 15 percent
interest rate.
2. Money is not a resource. Money is not an economic resource. In the form of
coins, paper currency, or chequing accounts, money is not productive; it cannot
produce goods and services. However, businesses buy the use of money because
it can be used to acquire capital goods such as factories, machinery, warehouses,
and so on. Such facilities clearly do contribute to production. Thus, in hiring the
use of money capital, business executives are often indirectly buying the use of
real capital goods.
loanable
funds Loanable Funds Theory of Interest
theory of
interest The In macroeconomics the interest rate is viewed through the lens of the economy’s
concept that the total supply of and demand for money. But since our present focus is on microeco-
supply of and de- nomics, it will be useful to consider a more micro-based theory of interest here.
mand for loanable
funds determine
Specifically, the loanable funds theory of interest explains the interest rate not in
the equilibrium rate terms of the total supply of and demand for money but, rather, in terms of supply of
of interest. and demand for funds available for lending (and borrowing). As Figure 16-2 shows, the
 chapter sixteen • rent, interest, and profit 423

FIGURE 16-2 THE MARKET FOR LOANABLE FUNDS

The upsloping supply curve
S for loanable funds reflects
the idea that at higher inter- S
est rates, households will

Interest rate (percent)

defer more of their present
consumption (save more),
making more funds available
for lending. The downsloping
demand curve D for loanable
funds indicates that busi- i=
8%
nesses will borrow more at
lower interest rates than at
higher interest rates. At the
equilibrium interest rate D
(here, 8 percent), the quanti-
ties of loanable funds lent
and borrowed are equal 0 F0
(here, F0 each).
Quantity of loanable funds

equilibrium interest rate (here, 8 percent) is the rate at which the quantities of loan-
able funds supplied and demanded are equal.
Let’s first consider the loanable funds theory in simplified form. Specifically,
assume households or consumers are the sole suppliers of loanable funds and busi-
nesses are the sole demanders. Also assume that lending occurs directly between
households and businesses; there are no intermediate financial institutions.

SUPPLY OF LOANABLE FUNDS

The supply of loanable funds is represented by curve S in Figure 16-2. Its upward
slope indicates that households will make available a larger quantity of funds at
high interest rates than at low interest rates. Most people prefer to use their income
to purchase pleasurable goods and services today, rather than to delay purchases to
sometime in the future. For people to delay consumption and increase their saving,
they must be compensated by an interest payment. The larger the amount of that
payment, the greater the deferral of household consumption and thus the greater
the amount of money made available for loans.
There is disagreement among economists as to how much the quantity of loan-
able funds made available by suppliers changes in response to changes in the inter-
est rate. Most economists view saving as being relatively insensitive to changes in
the interest rate. The supply curve of loanable funds may, therefore, be more inelas-
tic than S in Figure 16-2 implies.

DEMAND FOR LOANABLE FUNDS

Businesses borrow loanable funds primarily to add to their stocks of capital goods,
such as new plants or warehouses, machinery, and equipment. Assume that a firm
wants to buy a machine that will increase output and sales such that the firm’s total
<www.mises.com/ revenue will rise by $110 for the year. Also assume that the machine costs $100 and
humanaction/
chap19sec1.asp>
has a useful life of just one year. Comparing the $10 earned with the $100 cost of the
The phenomenon of machine, we find that the expected rate of return on this investment is 10 percent
interest (= $10/$100) for one year.
424 Part Three • Microeconomics of Resource Markets

To determine whether the investment would be profitable and whether it should

be made, the firm must compare the interest rate—the price of loanable funds—with
the 10 percent expected rate of return. If funds can be borrowed at some rate less
than the rate of return, say, at 8 percent, as in Figure 16-2, then the investment is
profitable and should be made. But if funds can be borrowed only at an interest rate
above the 10 percent rate of return, say, at 14 percent, the investment is unprofitable
and should not be made.
Why is the demand for loanable funds downsloping, as in Figure 16-2? At higher
interest rates fewer investment projects will be profitable and hence a smaller quan-
tity of loanable funds will be demanded. At lower interest rates, more investment
projects will be profitable and, therefore, more loanable funds will be demanded.
Indeed, as we have just seen, it is profitable to purchase the $100 machine if funds
can be borrowed at 8 percent but not if the firm must borrow at 14 percent.

Extending the Model

We now make this simple model more realistic in several ways.

FINANCIAL INSTITUTIONS
Households rarely lend their savings directly to businesses that are borrowing
funds for investment. Instead, they place their savings in chartered banks (and other
financial institutions). The banks pay interest to savers to attract loanable funds and
in turn lend those funds to businesses. Businesses borrow the funds from the banks,
paying them interest for the use of the money. Financial institutions profit by charg-
ing borrowers higher interest rates than the interest rates they pay savers. Both
interest rates, however, are based on the supply of and demand for loanable funds.

CHANGES IN SUPPLY
Anything that causes households to be thriftier will prompt them to save more at
each interest rate, shifting the supply curve rightward. For example, if interest
earned on savings were to be suddenly exempted from taxation, we would expect
the supply of loanable funds to increase and the equilibrium interest rate to
decrease.
Conversely, a decline in thriftiness would shift the supply-of-loanable-funds
curve leftward and increase the equilibrium interest rate. For example, if the gov-
ernment expanded social insurance to cover the costs of hospitalization, prescrip-
tion drugs, and retirement living more fully, the incentive of households to save
might diminish.

CHANGES IN DEMAND
On the demand side, anything that increases the rate of return on potential invest-
ments will increase the demand for loanable funds. Let’s return to our earlier exam-
ple, where a firm would receive additional revenue of $110 by purchasing a $100
machine and, therefore, would realize a 10 percent return on investment. What fac-
tors might increase or decrease the rate of return? Suppose a technological advance
raised the productivity of the machine so that the firm’s total revenue increased by
$120 rather than $110. The rate of return would then be 20 percent, not 10 percent.
Before the technological advance, the firm would have demanded zero loanable
funds at, say, an interest rate of 14 percent, but now it will demand $100 of loanable
funds at that interest rate, meaning that the demand curve for loanable funds has
shifted to the right.
 chapter sixteen • rent, interest, and profit 425

Similarly, an increase in consumer demand for the firm’s product will increase the
price of its product. So even though the productivity of the machine is unchanged,
its potential revenue will rise from $110 to perhaps $120, increasing the firm’s rate
of return from 10 to 20 percent. Again, the firm will be willing to borrow more than
previously at our presumed 8 or 14 percent interest rate, implying that the demand
curve for loanable funds has shifted rightward. This shift in demand increases the
equilibrium interest rate.
Conversely, a decline in productivity or in the price of the firm’s product would shift
the demand curve for loanable funds leftward, reducing the equilibrium interest rate.

OTHER PARTICIPANTS
We must recognize there are other participants on both the demand and the supply
sides of the loanable funds market. For example, while households are suppliers of
loanable funds, many are also demanders of such funds. Households borrow to
finance expensive purchases such as housing, automobiles, furniture, and house-
hold appliances. Governments also are on the demand side of the loanable funds
market when they borrow to finance budgetary deficits. And businesses that have
revenues in excess of their current expenditures may offer some of those revenues
in the market for loanable funds. Thus, like households, businesses operate on both
the supply and the demand sides of the market.
Finally, in addition to gathering and making available the savings of households,
banks and other financial institutions also increase funds through the lending
<www.bankofcanada.
process and decrease funds when loans are paid back and not lent out again. The
ca/en/> Bank of Canada (the nation’s central bank) controls the amount of this bank activ-
Bank of Canada ity and thus influences interest rates.
This fact helps answer one of our chapter-opening questions: Why did the inter-
est rate on one-year Guaranteed Investment Certificate drop from 5.08 percent in
March 2000 to 3.18 percent in March 2001? There are two reasons: (1) the demand
for loanable funds decreased because businesses did not need to purchase more
capital goods; and (2) the Bank of Canada took monetary actions that increased the
supply of loanable funds. (Key Question 4)

Range of Interest Rates

TABLE 16-1 SELECTED
INTEREST RATES,
JANUARY 2001
Type of interest rate
10-year Government of Canada bond
New Brunswick 2008 bond
B.C. 2008 bond
Canadian Pacific 2009 bond
5-year closed mortgage
91-day Treasury bill (Government
of Canada)
Prime rate (rate charged by banks to
their best corporate customers)
Visa interest rate
Although economists often speak in terms of a
single interest rate, a number of interest rates
exist. Table 16-1 lists several interest rates often
Annual percentage referred to in the media. These rates range from
5.43 to 18.50 percent. Why are there differences?
5.43
5.80 ● Risk Loans to different borrowers for
different purposes carry varying degrees
5.73
of risk. The greater the chance that the
6.96
borrower will not repay the loan, the
7.40 higher the interest rate the lender will
charge to compensate for that risk.
5.20
● Maturity The time length of a loan or its
maturity (when it needs to be paid back)
7.50
also affects the interest rate. Other things
18.50
equal, longer-term loans command higher
interest rates than shorter-term loans.
426 Part Three • Microeconomics of Resource Markets

The long-term lender suffers the inconvenience and possible financial sacrifice
of forgoing alternative uses for the money for a greater period.
● Loan size If there are two loans of equal maturity and risk, the interest rate
on the smaller of the two loans usually will be higher. The costs of issuing a
large loan and a small loan are about the same in dollars, but the cost is greater
as a percentage of the smaller loan.
● Market imperfections Market imperfections also explain some interest rate
differentials. The small-town bank that monopolizes local lending may charge
high interest rates on consumer loans because households find it inconvenient
and costly to shop around at banks in distant cities. The large corporation,
however, can survey rival lenders to float a new bond issue and secure the
lowest obtainable rate.

Pure Rate of Interest

pure rate Economists and financial specialists talk of “the” interest rate to simplify the clus-
of interest ter of rates (Table 16-1). When they do so, they usually have in mind the pure rate
An essentially risk- of interest. The pure rate is best approximated by the interest paid on long-term,
free, long-term
interest rate not
virtually riskless securities such as long-term bonds of the Canadian government.
influenced by mar- This interest payment can be thought of as being made solely for the use of money
ket imperfections. over an extended time, because risk and administrative costs are negligible and the
interest rate on these bonds is not distorted by market imperfections. In Spring 2001
the pure rate of interest in Canada was 5.41 percent.

Role of the Interest Rate

<bonds.about.com/ The interest rate is a critical price that affects the level and composition of investment
money/bonds/library/ goods production, as well as the amount of R&D spending.
weekly/aa091699.htm>
Yield spreads, thick
and thin
INTEREST AND TOTAL OUTPUT
A lower equilibrium interest rate encourages businesses to borrow more for invest-
ment. As a result, total spending in the economy rises, and if the economy has
unused resources, so does total output. Conversely, a higher equilibrium interest
rate discourages business from borrowing for investment, reducing investment and
total spending. Such a decrease in spending may be desirable if any economy is
experiencing inflation.
Government often manipulates the interest rate to try to expand investment and
output on the one hand, or to reduce investment and inflation on the other. Gov-
ernment affects the interest rate by changing the supply of money. Increases in the
money supply increase the supply of loanable funds, causing the equilibrium inter-
est rate to fall. This boosts investment spending and expands the economy. In con-
trast, decreases in the money supply decrease the supply of loanable funds, boosting
the equilibrium interest rate. As a result, investment is constrained and so is the
economy.

INTEREST AND THE ALLOCATION OF CAPITAL

Prices are rationing devices. The price of money—the interest rate—is certainly no
exception. The interest rate rations the available supply of loanable funds to invest-
ment projects that have expected rates of return at or above the interest rate cost of
the borrowed funds.
 chapter sixteen • rent, interest, and profit 427

If, say, the computer industry expects to earn a return of 12 percent on the money
it invests in physical capital and it can secure the required funds at an interest rate
of 8 percent, it can borrow and expand its physical capital. If the expected rate of
return on additional capital in the steel industry is only 6 percent, that industry will
find it unprofitable to expand its capital at 8 percent interest. The interest rate allo-
cates money, and ultimately physical capital, to those industries in which it will be
most productive and, therefore, most profitable. Such an allocation of capital goods
benefits society.
The interest rate does not perfectly ration capital to its most productive uses.
Large oligopolistic borrowers may be better able than competitive borrowers to pass
interest costs on to consumers, because they can change prices by controlling out-
put. Also, the size, prestige, and monopsony power of large corporations may help
them obtain funds on more favourable terms than can smaller firms, even when the
smaller firms have similar rates of profitability.

INTEREST AND THE LEVEL AND COMPOSITION OF R&D SPENDING

Recall from Chapter 12 that, like the investment decision, the decision on how much
to spend on R&D depends on the cost of borrowing funds in relationship to the
expected rate of return. Other things equal, the lower the interest rate, and thus
the lower the cost of borrowing funds for R&D, the greater the amount of R&D
spending that is profitable. The higher the interest rate, the less the amount of
R&D spending.
Also, the interest rate allocates R&D funds to those firms and industries for
which the expected rate of return on R&D is the greatest. Ace Microcircuits may
have an expected rate of return of 16 percent on an R&D project, while Glow
Paints has only a 2 percent expected rate of return on its R&D project. With the inter-
est rate at 8 percent, loanable funds will flow to Ace, not to Glow. Society will ben-
efit by having R&D spending allocated to projects that have sufficiently high
expected rates of return to justify using scarce resources for R&D rather than for
other purposes.

NOMINAL AND REAL INTEREST RATES

nominal This discussion of the role of the interest in investment decisions and in R&D deci-
interest
rate The interest sions assumes that there is no inflation. If inflation exists, we must distinguish
rate expressed in between nominal and real interest rates, just as we needed to distinguish between
terms of annual nominal and real wages in Chapter 15. The nominal interest rate is the rate of inter-
amounts currently est expressed in dollars of current value. The real interest rate is the rate of interest
charged for interest
and not adjusted
expressed in purchasing power—dollars of inflation-adjusted value. (For a com-
for inflation. parison of nominal interest rates on bank loans in selected countries, see Global Per-
spective 16.1.)
real For example, suppose the nominal interest rate and the rate of inflation are both
interest 10 percent. If you borrow $100, you must pay back $110 a year from now. However,
rate because of 10 percent inflation, each of these 110 dollars will be worth 10 percent
The interest rate
expressed in dollars less. Thus, the real value or purchasing power of your $110 at the end of the year is
of constant value only $100. In inflation-adjusted dollars you are borrowing $100 and at year’s end
(adjusted for infla- you are paying back $100. While the nominal interest rate is 10 percent, the real
tion); equal to the interest rate is zero. We determine this by subtracting the 10 percent inflation rate
nominal interest
rate less the
from the 10 percent nominal interest rate.
expected rate It is the real interest rate, not the nominal rate, that affects investment and R&D
of inflation. decisions. (Key Question 6)
428 Part Three • Microeconomics of Resource Markets

16.1

Short-term nominal Short Term Interest Rate, 2000

interest rates, 0 10 20 30 40 50 60 70 80
selected nations
Turkey
These data show the short- Mexico
term nominal interest rates Hungary
Poland
(those on three-month loans)
Greece
in various countries in 2000. South Korea
Because these are nominal United Kingdom
rates, much of the variation United States
reflects differences in rates Canada
Sweden
of inflation, but differences
Japan
in central bank monetary
policies and in risk of default Source: Organisation for Economic Co-operation
and Development, <www.oecd.org/>, 2000.
also explain the variations.

Application: Usury Laws

usury laws A number of jurisdictions in the United States (but not Canada) have passed usury
State laws that laws, which specify a maximum interest rate at which loans can be made. The pur-
specify the maxi- pose is to hold down the interest cost of borrowing, particularly for low-income bor-
mum legal interest
rate at which loans rowers. (Usury simply means exorbitant interest.)
can be made. Figure 16-2 helps us assess the impact of such legislation. The equilibrium inter-
est rate is 8 percent, but suppose a usury law specifies that lenders cannot charge
more than 6 percent. The effects are as follows:
● Nonmarket rationing At 6 percent, the quantity of loanable funds demanded
exceeds the quantity supplied: there is a shortage of loanable funds. Since the
market interest rate no longer can ration the available loanable funds to bor-
rowers, lenders (banks) have to do the rationing. We can expect them to make
loans only to the most creditworthy borrowers (mainly wealthy, high-income
people), which defeats the goal of the usury law. Low-income, riskier borrow-
ers are excluded from the market and may be forced to turn to loan sharks who
charge illegally high interest rates.
● Gainers and losers Creditworthy borrowers gain from usury laws because
they pay below-market interest rates. Lenders (ultimately bank sharehold-
ers) are losers, because they receive 6 percent rather than 8 percent on each
dollar lent.
● Inefficiency We have just seen how the equilibrium interest rate allocates
money to the investments and the R&D projects whose expected rate of return
is greatest. Under usury laws, funds are much less likely to be allocated by
banks to the most productive projects. Suppose Wilson has a project so prom-
ising she would pay 10 percent for funds to finance it. Chen has a less-
promising investment, and he would be willing to pay only 7 percent for
financing. If the market were rationing funds, Wilson’s highly productive
 chapter sixteen • rent, interest, and profit 429

project would be funded and Chen’s would not. That allocation of funds would
be in the interest of both Wilson and society. But with a 6 percent usury rate,
Chen may get to the bank before Wilson and receive the loanable funds at 6 per-
cent, so, Wilson may not get funded. Legally controlled interest rates may thus
inefficiently ration funds to less-productive investments or R&D projects.

● Interest is the price paid for the use of money. total spending and total output; it also allocates
money and real capital to specific industries
● In the loanable funds model, the equilibrium in-
and firms. Similarly, the interest rate affects the
terest rate is determined by the demand for and
level and composition of R&D spending.
supply of loanable funds.
● Usury laws that establish an interest rate ceiling
● The range of interest rates is influenced by
below the market interest rate may (1) deny credit
risk, maturity, loan size, taxability, and market
to low-income people, (2) subsidize high-income
imperfections.
borrowers and penalize lenders, and (3) diminish
● The equilibrium interest rate affects the total the efficiency with which loanable funds are allo-
level of investment and, therefore, the levels of cated to investment and R&D projects.

Economic Profit
We have seen in previous chapters that economists define profit narrowly. To
accountants, profit is what remains of a firm’s total revenue after it has paid indi-
viduals and other firms for the materials, capital, and labour they have supplied to
the firm. To the economist, this definition overstates profit. The reason is that the
explicit accountant’s view of profit considers only explicit costs: payments made by the firm
costs The to outsiders. It ignores implicit costs: the monetary income the firm sacrifices when
monetary payments it uses resources that it owns, rather than supplying those resources to the market.
a firm must make
to an outsider to
The economist considers implicit costs to be opportunity costs and hence to be real
obtain a resource. costs that must be accounted for in determining profit. Economic, or pure, profit is
what remains after all costs—both explicit and implicit costs, the latter including a
implicit normal profit—have been subtracted from a firm’s total revenue. Economic profit
costs The may be either positive or negative (a loss).
monetary incomes
a firm sacrifices
For example, suppose a shopkeeper owns her own bagel shop, including the
when it uses a land, building, and equipment, and provides her own labour. As economists see it,
resource it owns she grossly overstates her economic profit if she merely subtracts from her total rev-
rather than supply- enue the payments she makes to outsiders for, say, baking ingredients, electricity,
ing the resource to and insurance. She has not yet subtracted the cost of the resources she has con-
the market.
tributed. Those costs are the rent, interest, and wage payments she could have
economic received by making her land, labour, and capital resources available for alternative
(pure) profit uses. They are her implicit costs, and they must be taken into account in determin-
The total revenue of ing her economic profit. She certainly would have to pay those costs if outsiders
a firm less its eco- supplied these resources to her bagel shop.
nomic costs (which
includes both explicit
costs and implicit Role of the Entrepreneur
costs); also called
above normal profit. The economist views profit as the return on a particular type of human resource: entre-
preneurial ability. We know from earlier chapters that the entrepreneur (1) combines
resources to produce a good or service, (2) makes basic, nonroutine policy decisions
 430 Part Three • Microeconomics of Resource Markets

for the firm, (3) introduces innovations in the form of new products or new produc-
tion processes, and (4) bears the economic risks associated with all those functions.
Part of the entrepreneur’s return is a normal profit, which is the minimum pay-
<www.henrygeorge.org/ ment necessary to retain the entrepreneur in the current line of production. We saw
cap.htm> in Chapter 8 that normal profit is a cost—the cost of using entrepreneurial ability for
Capital, interest, a particular purpose. We saw also that a firm’s total revenue may exceed its total
and profit
cost; the excess revenue above all costs is its economic profit. This residual profit also
goes to the entrepreneur. The entrepreneur is the residual claimant: the resource that
normal receives what is left after all costs are paid.
profit The Why should there be residual profit? We next examine three possible reasons, two
payment made by relating to the risks involved in business and one based on monopoly power.
a firm to obtain
and retain entrepre-
neurial ability. Sources of Economic Profit
Let’s first construct an artificial economic environment in which economic profit
would be zero. Then, by noting how the real world differs from such an environ-
ment, we will see where economic profit arises.
static We begin with a purely competitive, static economy. A static economy is one in
economy An which the basic forces such as resource supplies, technological knowledge, and con-
economy in which sumer tastes are constant and unchanging. As a result, all cost and supply data, and
resource supplies,
technological
all demand and revenue data, are constant.
knowledge, and Given the nature of these data, the economic future is perfectly certain. The out-
consumer tastes come of any price or production policy can be accurately predicted. Furthermore,
are constant and no product or production process is ever improved. Under pure competition any
unchanging. economic profit or loss that might have existed in an industry will disappear with
the entry or exit of firms in the long run. All costs, explicit and implicit, are just cov-
ered in the long run, so no economic profit exists in our static economy.
The idea of zero economic profit in a static competitive economy suggests that
profit is linked to the dynamic nature of real-world capitalism and its accompany-
ing uncertainty. Moreover, it indicates that economic profit may arise from a source
other than the directing, innovating, and risk-bearing functions of the entrepreneur.
That source is the presence of some amount of monopoly power.

RISK AND PROFIT

In a real, dynamic economy the future is not predictable; there is uncertainty. This
means that the entrepreneur must assume risks. Some or all economic profit may be
a reward for assuming risks.
insurable In linking economic profit with uncertainty and risk-bearing, we must distin-
risk An event guish between risks that are insurable and risks that are not. Some types of risk—
that would result fire, floods, theft, and accidents to employees—are measurable; that is, their
in a loss but whose
frequency of
frequency of occurrence can be estimated accurately. Firms can avoid losses due to
occurrence can be insurable risks by paying an annual fee (an insurance premium) to an insurance
estimated with con- company. The entrepreneur need not bear such risks.
siderable accuracy. However, the entrepreneur must bear the uninsurable risks of business, and
those risks are a potential source of economic profit. Uninsurable risks are mainly
uninsurable the uncontrollable and unpredictable changes in the demand and supply conditions
risk An event
that would result in facing the firm (and hence its revenues and costs). Uninsurable risks stem from three
a loss and whose general sources:
occurrence is
uncontrollable and 1. Changes in the general economic environment A downturn in business (a reces-
unpredictable. sion), for example, can lead to greatly reduced demand, sales, and revenues, and
 chapter sixteen • rent, interest, and profit 431

thus to business losses. A prosperous firm may experience such losses through
no fault of its own.
2. Changes in the structure of the economy Consumer tastes, technology, resource
availability, and prices change constantly in the real world, bringing changes in
production costs and revenues. For example, an airline earning economic profit
one year may find its profit plunging the next year as the result of a significant
increase in the price of jet fuel.
3. Changes in government policy A newly instituted regulation, the removal of a
tariff, or a change in a national policy may significantly alter the cost and revenue
data of the affected industry and firms.
Regardless of how such revenue and cost changes come about, they are risks that
the firm and entrepreneur must take to stay in business. Some or all the economic profit
in a real, dynamic economy may be compensation for taking risks.

INNOVATIONS AND PROFIT

Such uncertainties are beyond the control of the individual firm or industry and
thus external to it. One dynamic feature of capitalism, however—innovation—
occurs at the initiative of the entrepreneur. Business firms deliberately introduce
new methods of production to affect their costs favourably and new products to
affect their revenues also favourably. The entrepreneur purposely undertakes to
upset existing cost and revenue data in a way that promises to be profitable.
Again, uncertainty enters the picture. Despite exhaustive market surveys, new
products or modifications of existing products may be economic failures. Similarly,
of the many new novels, textbooks, movies, and music CDs that appear every year,
only a handful garner large profits. Nor is it known with certainty whether new pro-
duction machinery will actually yield projected cost economies. Thus, innovations
undertaken by entrepreneurs entail uncertainty and the possibility of losses, not just
the potential for increased profit. Some of the economic profit in an innovative economy
may be compensation for dealing with the uncertainty of innovation.

MONOPOLY AND PROFIT

So far, we have linked economic profit with the uncertainties surrounding (1) the
dynamic environment to which enterprises are exposed, and (2) the dynamic busi-
ness processes they initiate themselves. The existence of monopoly power is a final source
of economic profit. Because a monopolist can restrict output and deter entry, it may
persistently enjoy above-competitive prices and economic profit if demand is strong
relative to cost.
Economic uncertainty and monopoly are closely intertwined as sources of eco-
nomic profit. A firm with some monopoly power can reduce business risk, or at least
manipulate it enough to reduce its adverse effects, and thus increase and prolong
economic profit. Furthermore, a firm can use innovation as a source of monopoly
power and a means of sustaining itself and its economic profit.
An important distinction between profit stemming from uncertainty and profit
stemming from monopoly has to do with the social desirability of these two sources
of profit. Bearing business risk and undertaking innovation in an uncertain eco-
nomic environment are socially desirable functions. Obtaining monopoly profit is
not so socially desirable, since it is typically founded on reduced output, above-
competitive prices, and economic inefficiency. (Key Question 8)
432 Part Three • Microeconomics of Resource Markets

Functions of Profit
Economic profit is the main energizer of the capitalistic economy. It influences both
the level of economic output and the allocation of resources among alternative uses.

PROFIT AND TOTAL OUTPUT

The expectation of economic profit motivates firms to innovate. Innovation stimu-
lates new investment, thereby increasing total output and employment. Thus, the
pursuit of profit enhances economic growth by promoting innovation.

PROFIT AND RESOURCE ALLOCATION

Profit also helps to allocate resources among alternative lines of production. Entre-
preneurs seek profit and shun losses. The occurrence of economic profit in a indus-
try is a signal that society wants that particular industry to expand. It attracts
resources from industries that are not profitable. But the rewards of profit are more
than an inducement for an industry to expand; they also attract the financing that
firms need for expansion. In contrast, losses penalize businesses that fail to adjust
their productive efforts to the goods and services most preferred by customers.
Losses signal society’s desire for the afflicted industries to contract.
So, in terms of our chapter-opening question, Nortel Networks experienced large
revenue and profit increases because it is selling Internet switching devices and
optical equipment that society greatly wants. The profit increase signals that soci-
ety wants more of its scarce resources allocated to that use. Corel Corporation, in
contrast, was not providing service equivalent in value to the costs of the resources
used to provide it—the company therefore suffered a loss. The loss signals that soci-
ety would benefit from a reallocation of some of those resources to some other use.
Profits and losses do not, however, result in an allocation of resources that is per-
fectly attuned to consumer preferences. The presence of monopoly, for example,
impedes the movement of firms and resources from industry to industry in response
to economic profit.

● Pure or economic profit is what remains after all
explicit and implicit costs (including a normal
profit) are subtracted from a firm’s total revenue.
● Economic profit has three sources: the bearing
of uninsurable risk, the uncertainty of innova-
tion, and monopoly power.
● Profit and profit expectations affect the levels of
investment, total spending, and domestic out-
put; profit and loss also allocate resources
among alternative uses.

Income Shares
Our discussion in this and in the preceding chapter would not be complete without
a brief re-examination of how Canadian national income is distributed among
wages, rent, interest, and profit.
Let’s look at Table 16-2. Although the income categories shown in that chart do
not neatly fit the economic definitions of wages, rent, interest, and profits, they do
 chapter sixteen • rent, interest, and profit 433

TABLE 16-2 RELATIVE SHARES OF DOMESTIC INCOME,

1926–2000 (SELECTED YEARS OR PERIOD
AVERAGES OF SHARES FOR INDIVIDUAL YEARS)
Year or Wages, Corporation Interest Accrued net Net income Inventory Net domestic
period salaries, profits and mis- income of of nonfarm valuation income at
and supple- before cellaneous farmers unincor- adjustment factor cost
mentary taxes investment from farm porated
labour income production business
income including
rent

1926 55.3% 11.4% 3.2% 14.1% 14.9% 1.1% 100%

1929 60.0 12.9 3.7 8.0 15.7 –0.3 100
1937 62.6 15.6 3.1 6.9 13.9 –2.1 100
1941 61.9 18.1 2.8 7.0 12.6 –2.4 100
1945 63.4 13.1 2.7 9.2 12.0 –0.4 100
1951 60.7 17.9 2.5 10.5 12.0 –3.6 100
1957–60 67.0 13.7 3.9 3.6 12.0 –0.2 100
1961–65 67.7 14.2 4.3 3.6 10.6 –0.3 100
1966–70 70.9 13.5 4.7 2.7 8.8 –0.6 100
1971 73.0 12.2 5.5 2.0 8.2 –0.9 100
1973 70.6 16.0 5.7 3.0 7.2 –2.5 100
1975 71.2 14.8 7.1 2.9 6.0 –2.0 100
1979 69.3 16.4 10.7 1.7 5.4 –3.5 100
1982 72.7 9.2 12.2 1.2 5.8 –1.1 100
1990 72.6 8.7 11.1 0.6 7.0 –0.0 100
1994 73.5 10.0 10.1 0.4 6.9 –0.9 100
1999 75.2 10.5 5.0 0.2 6.2 2.9 100
2000 69.6 15.9 6.6 0.3 7.9 –0.3 100
Source: 1926–1982: Statistics Canada, National Income and Expenditure Accounts, Annual estimates 1926–1986, Table 70; for other
years Statistics Canada, National Income and Expenditure Accounts. For updates, visit Statistics Canada at <www.statcan.ca/
english/Pgdb/Economy/ Economic/econ03.htm>
Visit www.mcgrawhill.ca/college/mcconnell9 for data update.

provide insight about income shares in Canada. Note the dominant role of labour
resource and thus labour income in the Canadian economy. Even with labour
income defined narrowly as “wages and salaries,” labour receives about 70 percent
of national income. But some economists contend that the income of proprietors is
largely composed of implicit wages and salaries and should be added to the “wages
and salaries” category to determine labour income. When we use this broad defini-
tion, labour’s share rises to nearly 80 percent of national income, a percentage that
has been remarkably stable in Canada since 1926. That leaves about 20 percent for
capitalists in the form of rent, interest, and profit. Ironically, capitalist income is a
relatively small share of the Canadian economy, which we call a capitalist system.
434 Part Three • Microeconomics of Resource Markets
Borrowing and lending—receiv-
ing and granting credit—are a
way of life. Individuals receive
credit when they negotiate a
mortgage loan and when they
use their credit cards. Individu-
als make loans when they open
a savings account in a chartered
bank or buy a bond.
It is sometimes difficult to de-
termine exactly how much inter-
est we pay and receive when we
borrow and lend. Let’s suppose
that you borrow $10,000, which
you agree to repay with $1000 of
interest at the end of one year. In
this instance, the interest rate is
10 percent per year. To deter-
mine the interest rate i, we com-
pare the interest paid with the
amount borrowed:
$1000
i = ᎏ = 10%
$10,000
But in some cases a lender—say,
a bank—will discount the inter-
est payment at the time the loan
is made. Thus, instead of giving
the borrower $10,000, the bank
discounts the $1000 interest pay-
ment in advance, giving the bor-
rower only $9000. This increases
the interest rate:
$1000
i = ᎏ = 11%
$9000
DETERMINING THE PRICE OF CREDIT
A variety of lending practices may cause the effective
interest rate to be quite different from what it appears to be.
While the absolute amount of
interest paid is the same, in this
second case the borrower has
only $9000 available for the
year.
An even more subtle point is
that, to simplify their calcula-
tions, many financial institutions
assume a 360-day year (twelve
30-day months), which means
the borrower has the use of the
lender’s funds for five days less
than the normal year. This use of
a short year also increases the
actual interest rate paid by the
borrower.
The interest rate paid may
change dramatically if a loan is
repaid in installments. Suppose
a bank lends you $10,000 and
charges interest in the amount
of $1000 to be paid at the end of
the year. But the loan contract
requires that you repay the
$10,000 loan in 12 equal monthly
installments. In effect, then, the
average amount of the loan out-
standing during the year is only
$5000. Therefore:
$1000
i = ᎏ = 20%
$5000
Here interest is paid on the total
amount of the loan ($10,000)
rather than on the outstanding
balance (which averages $5000
for the year), making for a much
higher interest rate.
Another factor that influences
the effective interest rate is
whether interest is compounded.
Suppose you deposit $10,000 in
a savings account that pays a
10 percent interest rate com-
pounded seminannually. In other
words, interest is paid on your
loan to the bank twice a year. At
the end of the first six months,
$500 of interest (10 percent of
$10,000 for half a year) is added
to your account. At the end of the
year, interest is calculated on
$10,500 so that the second in-
terest payment is $525 (10 per-
cent of $10,500 for half a year).
Thus:
$1025
i = ᎏ = 10.25%
$10,000
This means that a bank adver-
tising a 10 percent interest rate
compounded seminannually is
actually paying more interest
to its customers than a competi-
tor paying a simple (noncom-
pounded) interest rate of 10.20
percent.
“Let the borrower (or deposi-
tor) beware” remains a fitting
motto in the world of credit.
 chapter sixteen • rent, interest, and profit 435

chapter summary
1. Economic rent is the price paid for the use of
land and other natural resources whose total
supplies are fixed.
2. Rent is a surplus payment that is socially
unnecessary since land would be available
to the economy even without rental pay-
ments. The idea of land rent as a surplus
payment gave rise to the single-tax move-
ment of the late nineteenth century.
3. Differences in land rent result from differ-
ences in the fertility and climatic features of
the land and difference in location.
4. Although land rent is a surplus payment
rather than a cost to the economy as a
whole, to individual firms and industries,
rental payments are correctly regarded as
costs. These payments must be made to
gain the use of land, which has alterna-
tive uses.
5. Interest is the price paid for the use of
money. In the loanable funds theory, the
equilibrium interest rate is determined by
the demand for and supply of loanable
funds. Other things equal, an increase in the
supply of loanable funds reduces the equi-
librium interest rate, whereas a decrease in
supply increases it; increases in the demand
for loanable funds raise the equilibrium
interest rate, whereas decreases in demand
reduce it.
6. Interest rates vary in size because loans dif-
fer as to risk, maturity, amount, and taxabil-
ity; market imperfections cause additional
variations. The pure rate of interest is the
interest rate on long-term, virtually riskless,
Government of Canada long-term bonds.
7. The equilibrium interest rate influences the
level of investment and helps ration finan-
cial and physical capital to specific firms
and industries. Similarly, this rate influences
the size and composition of R&D spend-
ing. The real interest rate, not the nominal
rate, is critical to investment and R&D
decisions.
8. Although designed to make funds available
to low-income borrowers, usury laws tend to
allocate credit to high-income persons, sub-
sidize high-income borrowers at the expense
of lenders, and lessen the efficiency with
which loanable funds are allocated.
9. Economic, or pure, profit is the difference
between a firm’s total revenue and the sum
of its explicit and implicit costs, the latter
including a normal profit. Profit accrues to
entrepreneurs for assuming the uninsurable
risks associated with organizing and direct-
ing economic resources and for innovating.
Profit also results from monopoly power.
10. Profit expectations influence innovation and
investment activities and, therefore, the
economy’s levels of employment and eco-
nomic growth. The basic function of profits
and losses, however, is to allocate resources
in accord with consumers’ preferences.
11. The largest share of national income—about
70 percent—goes to labour, a share narrowly
defined as “wages and salaries.” When
labour’s share is more broadly defined to
include “proprietors’ income,” it rises to
about 80 percent of national income, leaving
about 20 percent as capital’s share.

terms and concepts

economic rent, p. 418
incentive function of price,
p. 419
single-tax movement, p. 420
loanable funds theory of
interest, p. 422
pure rate of interest, p. 426
nominal interest rate, p. 427
real interest rate, p. 427
usury laws, p. 428
explicit costs, p. 429
implicit costs, p. 429
economic (pure) profit, p. 429
normal profit, p. 430
static economy, p. 430
insurable risks, p. 430
uninsurable risks, p. 430

study questions
1. How does the economist’s use of the term make land available, rental payments are
“rent” differ from everyday usage? Explain: very useful in guiding land into the most pro-
“Though rent need not be paid by society to ductive uses.”
436 Part Three • Microeconomics of Resource Markets
2. KEY QUESTION Explain why eco-
nomic rent is a surplus payment when viewed
by the economy as a whole but as a cost of
production from the standpoint of individual
firms and industries. Explain: “Rent performs
no ‘incentive function’ in the economy.”
3. If money is not an economic resource, why is
interest paid and received for its use? What
considerations account for the fact that inter-
est rates differ greatly on various types of
loans? Use those considerations to explain
the relative sizes of the interest rates on the
following:
a. A 10-year $1000 government bond
b. A $20 pawnshop loan
c. A 30-year mortgage loan on a $145,000
house
d. A 24-month $12,000 bank loan to finance
the purchase of an automobile
e. A 60-day $100 loan from a personal fi-
nance company
4. KEY QUESTION Why is the supply
of loanable funds upsloping? Why is the
demand for loanable funds downsloping?
Explain the equilibrium interest rate. List
some factors that might cause it to change.
5. What are the major economic functions of the
interest rate? How might the fact that many
businesses finance their investment activities
internally affect the efficiency with which the
interest rate performs its functions?
6. KEY QUESTION Distinguish between
nominal and real interest rates. Which is
more relevant in making investment and
R&D decisions? If the nominal interest rate is
12 percent and the inflation rate is 8 percent,
what is the real rate of interest?
7. Historically, usury laws that put below-
equilibrium ceilings on interest rates have
been used in the United States to make
credit available to poor people who could
internet application question
1. The real interest rate is the nominal rate less
the rate of inflation. Assume the Consumer
Price Index (CPI) is a proxy for the inflation
rate and one-year Treasury Bill rates repre-
sent the nominal interest rate. Find the current
CPI at <www.statcan.ca/english/econoind/
cpia.htm>, and then subtract it from the cur-
not otherwise afford to borrow. Critics
contend that poor people are those most
likely to be hurt by such laws. Which view is
correct?
8. KEY QUESTION How do the concepts
of accounting profit and economic profit dif-
fer? Why is economic profit smaller than
accounting profit? What are the three basic
sources of economic profit? Classify each of
the following according to those sources:
a. A firm’s profit from developing and
patenting a new medication that greatly
reduces cholesterol and thus diminishes
the likelihood of heart disease and stroke
b. A restaurant’s profit that results from con-
struction of a new highway past its door
c. The profit received by a firm due to an
unanticipated change in consumer tastes
9. Why is the distinction between insurable and
uninsurable risks significant for the theory of
profit? Carefully evaluate: “All economic
profit can be traced to either uncertainty or
the desire to avoid it.” What are the major
functions of economic profit?
10. Explain the absence of economic profit in a
purely competitive, static economy. Realiz-
ing that the major function of profit is to allo-
cate resources according to consumer
preferences, describe the allocation of
resources in such an economy.
11. What is the rent, interest, and profit share of
national income if proprietors’ income is
included within the labour (wage) share?
12. (The Last Word) Assume that you borrow
$5000 and pay back the $5000 plus $250 in
interest at the end of the year. Assuming no
inflation, what is the real interest rate? What
would the interest rate be if the $250 of inter-
est had been discounted at the time the loan
was made? What would the interest rate be
if you were required to repay the loan in 12
equal monthly installments?
rent one-year Treasury Bill rate <www.bank-
banque-canada.ca/pdf/monmrt.pdf>. Repeat
the process for the one-month Treasury Bills
and the CPI rate of change for the past one
month. Is there a difference between the 1-
month and the 12-month real interest rates?
If so, why is there a difference?
 SEVENTEEN

Income
Inequality
and Poverty

E
vidence that suggests wide income dis-

parity in Canada is easy to find. In 1999

the annual paycheque of Mathew Bar-

IN THIS CHAPTER rett, the chief executive officer (CEO) of the
Y OU WILL LEARN:
Bank of Montreal totalled more than $20 mil-
The facts about income
inequality in Canada lion; the CEO of Canadian Tire received almost
and how to measure it.
• $17 million; and the CEO of Nortel Networks
The causes of income inequality.
• was paid more than $10 million. In contrast,
That there is a tradeoff
the salary of the prime minister of Canada
between income equality
and economic efficiency. was $200,000 that year, and the typical
•
The distinction between schoolteacher earned $55,000. A full-time
absolute and relative poverty.
• minimum-wage worker at a fast-food restau-
About the extent of relative
poverty in Canada. rant made about $12,000.
•
About Canada’s income
maintenance system.
438 Part Three • Microeconomics of Resource Markets

In 1997 about 5.2 million Canadians—or 17.5 percent of the population—lived in

poverty. The richest fifth of the population received 40 percent of total income, while
the poorest fifth received only 5 percent.
What are the sources of income inequality? Is income inequality rising or falling?
Is Canada making progress against poverty? What are the major income mainte-
nance programs in Canada? These are some of the questions that we will answer in
this chapter.

Facts about Income Inequality

income Average family income in Canada is among the highest in the world; in 1997, it was
inequality $57,446 per family. But that average tells us nothing about income inequality. To
The unequal distri- learn about that, we must examine how income is distributed around the average.
bution of an econ-
omy’s total income
among households
or families.
Distribution of Personal Income by Income Category
One way to measure income inequality is to look at the percentages of families
lorenz in a series of income categories. Table 17-1 shows that 11.3 percent of all families
curve A curve had annual before-tax incomes of less than $20,000 in 1997, while 24.6 percent had
showing the distri-
bution of income in annual incomes of $75,000 or more. The data in the table suggest considerable
an economy. inequality of family income in Canada.

Distribution of Personal Income by

TABLE 17-1 THE DISTRIBUTION Quintiles (Fifths)
OF PERSONAL A second way to measure income inequality is
INCOME BY to divide the total number of income receivers
FAMILIES, 1997 into five numerically equal groups, or quintiles,
and examine the percentage of total personal
PANEL (A)
(before-tax) income received by each quintile.
Percentage of all
We do this in Table 17-2.
Personal income category families in this category

under $10,000 2.5 The Lorenz Curve

$10,001 to $14,999 3.7
We can display quintile distribution of personal
$15,000 to $19,999 5.1 income through a Lorenz curve. In Figure 17-1,
$20,000 to $29,999 13.0 we plot the cumulative percentage of families
$30,000 to $49,999 25.2 on the horizontal axis and the percentage of
$50,000 to $74,999 25.9 income they obtain on the vertical axis. The
diagonal line 0e represents a perfectly equal dis-
$75,000 and over 24.6
tribution of income because each point along that
100.0
line indicates that a particular percentage of
PANEL (B) families receive the same percentage of income.
In other words, points representing 20 percent
Average 1997 income for families $57,146
of all families receiving 20 percent of total
Median 1997 income for families $50,361 income, 40 percent receiving 40 percent, 60 per-
Number of families in Canada 8,394,000 cent receiving 60 percent, and so on, all lie on
Source: Statistics Canada, Income Distribution by Size in Canada, the diagonal line.
1997 (Ottawa, December 1998), Table 1, Cat. No. 13-207. By plotting the quintile data from Table 17-2,
we obtain the Lorenz curve for 1997. Observe
 chapter seventeen • income inequality and poverty 439

from point a that the bottom 20 percent of all

TABLE 17-2 PERCENTAGE OF families received 5.5 percent of the income; the
TOTAL BEFORE-TAX bottom 40 percent received 16.8 percent (= 5.5 +
AND AFTER-TAX 11.3), as shown by point b; and so forth. The
INCOME RECEIVED blue area between the diagonal line and the
BY EACH QUINTILE Lorenz curve is determined by the extent that
GROUP the Lorenz curve sags away from the diagonal
and indicates the degree of income inequality. If
AFTER the actual income distribution were perfectly
BEFORE TAX TAX equal, the Lorenz curve and the diagonal would
Quintile 1951 1965 1997 1997 coincide and the blue area would disappear.
Lowest 20% 4.4 4.4 4.6 5.5
At the opposite extreme is a situation of com-
plete inequality, where all families but one have
Second 20% 11.2 11.8 10.0 11.3
zero income. In that case the Lorenz curve
Third 20% 18.3 18.2 16.4 17.2 would coincide with the horizontal axis from 0
Fourth 20% 23.3 24.5 24.8 24.6 to point f (at 0 percent of income) and then
Highest 20% 42.8 41.1 44.2 41.4 would move immediately up from f to point e
100.0 100.0 100.0 100.0 along the vertical axis (indicating that a single
family has 100 percent of the total income). The
Source: Statistics Canada, Income Distributions: Incomes of Non-
Farm Families and Individuals in Canada, 1951–1965 (Ottawa,
entire area below the diagonal line (area 0ef)
1969); and Income After Taxes, Distribution by Size in Canada, 1996, would indicate this extreme degree of inequal-
1997 (Ottawa, 1997 and 1998), Cat. No. 13-210. ity. To generalize, the farther the Lorenz curve
sags away from the diagonal, the greater is the
degree of income inequality.
The Lorenz curve can also be plotted to contrast the income distribution
of different ethnic groups, different age groups, and different countries. (Key
Question 2)

FIGURE 17-1 THE LORENZ CURVE

The Lorenz curve is a 100 e
graph of the percent-
age of total income Lorenz curve
(actual distribution)
obtained by cumula- 80
tive percentages of
Percent of income

families. It is a con-
venient means of dis-
playing the degree of 60
Perfect equality
income inequality. d
Specifically, the area
between the diagonal 40
(the line of perfect
equality) and the c
Lorenz curve repre- Complete
20 inequality
sents the degree of
inequality in the b
Canadian distribution a f
of total income. 0
20 40 60 80 100
Percent of families
 440 Part Three • Microeconomics of Resource Markets

Income Mobility: The Time Dimension

The income data that we have been using so far have a major limitation: The income
accounting period of one year is too short to be very meaningful. Because the Sta-
tistics Canada data portray the distribution of income in only a single year, they may
conceal a more equal distribution over a few years, a decade, or even a lifetime. If
Dushan earns $1000 in year one and $100,000 in year two, while Jamel earns
$100,000 in year one and only $1000 in year two, do we have income inequality? The
answer depends on the period of measurement. Annual data would reveal great
income inequality, but there would be complete equality over the two-year period.
This point is important because evidence suggests considerable variation in the
distribution of income over time. For most income receivers, income starts at a rel-
atively low level, reaches a peak during middle age, and then declines. It follows
that if all people receive exactly the same stream of income over their lifetimes, con-
siderable income inequality would still exist in any specific year because of age
differences. In any single year, the young and the old would receive low incomes,
while the middle-aged receive high incomes.
If we change from a snapshot view of income distribution in a single year to a
time exposure view portraying incomes over much longer periods, we find consid-
erable movement of income receivers among income classes. This movement cor-
rectly suggests that income is more equally distributed over a 5-year, 10-year, or
20-year period than in a single year. Such movement of individuals or families from
income one income quintile to another over time is called income mobility.
mobility The In short, there is significant individual and family income mobility over time; for
movement of indi- many people, “low income” and “high income” are not permanent conditions. The
viduals and families
from one income longer the period considered, the more equal the distribution of income becomes.
quintile to another
over time. Effect of Government Redistribution
noncash The income data in Tables 17-1 and 17-2 include wages, salaries, dividends, and
transfer interest. They also include all cash transfer payments such as, employment insur-
Government trans- ance benefits and welfare assistance to needy families. The data are before-tax data
fer payments in the
form of goods and and therefore do not take into account the effects of personal income and Canada
services rather than Pension Plan contributions that are levied directly on income receivers. Nor do they
money. include in-kind or noncash transfers, which provide specific goods or services
rather than cash. Noncash transfers include such things as housing subsidies, den-
tal care, and drug benefit plans. Such transfers are “incomelike,” since they enable
recipients to purchase goods and services.
One economic function of government is to redistribute income, if society so
desires. Table 17-2 reveals that government redistributes income from higher- to
lower-income households through taxes and transfers. This point is made by the fact
that the Canadian distribution of household income before taxes and transfers are
taken into account is less equal than the distribution after taxes and transfers. With-
<www.jewishworldreview.
com/cols/ out government redistribution, the lowest 20 percent of households in 1997 would
williams071699.asp> have received only 4.6 percent of total income. With redistribution, they received 5.5
The Vanishing Poor percent, 24 percent more.
Which contributes more to redistribution, government taxes or government
transfers? The answer is transfers. Roughly 80 percent of the reduction in income
inequality is attributable to transfer payments, which account for more than 75 per-
cent of the income of the lowest quintile. Together with growth of job opportuni-
ties, transfer payments have been the most important means of alleviating poverty
in Canada.
 chapter seventeen • income inequality and poverty 441

Causes of Income Inequality

There are several causes of income inequality in Canada. In general, the market sys-
tem is an impersonal mechanism that embodies no conscience concerning what is
an equitable or just distribution of income. It is permissive of a high degree of
income inequality because it rewards individuals based on the contribution that
their resources make to producing society’s output.
The factors that contribute to income inequality follow.

Ability
People have different mental, physical, and aesthetic talents. Some have inherited
the exceptional mental qualities that are essential to such high-paying occupations
as medicine, corporate leadership, and law. Others are blessed with the physical
capacity and coordination to become highly paid professional athletes. A few have
the talent to become great artists or musicians or have the beauty to become top
fashion models. Others have very weak mental endowments and may work in low-
paying occupations or may not be able to earn any income at all. The intelligence
and skills of most people fall somewhere in-between.

Education and Training

Ability alone rarely produces high income; people must develop and refine their
capabilities through education and training. Individuals differ significantly in the
amount of education and training they obtain and thus in their capacity to earn
income. Such differences may be a matter of choice: Chin enters the labour force
after graduating from high school, while Rodriguez takes a job only after earning a
university degree. Other differences may be involuntary: Chin and her parents may
simply be unable to finance a postsecondary education.
People also receive varying degrees of on-the-job training, which contributes to
income inequality. Some workers learn valuable new skills each year on the job and,
therefore, experience significant income growth over time; others receive little or no
on-the-job training and earn no more at age 50 than they did at age 30. Moreover,
firms tend to select for advanced on-the-job training those workers who have the
highest level of formal education. That added training magnifies the education-
based income differences between less-educated and better-educated individuals.

Discrimination
Discrimination in education, hiring, training, and promotion undoubtedly con-
tributes to income inequality in Canada, although the degree is uncertain. If dis-
crimination restricts ethnic minorities or women to low-paying occupations, the
supply of labour will be great relative to demand in those occupations. Wages and
incomes will remain low. Conversely, discrimination reduces the competition that
whites or men face in the occupations in which they are predominant. Thus, labour
supply is artificially limited relative to demand in those occupations, with the result
that wages and incomes are high.

Preferences and Risks

Incomes also differ because of differences in preferences for market work relative to
leisure, market work relative to work in the household, and types of market work.
442 Part Three • Microeconomics of Resource Markets

People who choose to stay home with children, work part time, or retire early usu-
ally have less income than people who make other choices. For example, those who
are willing to take arduous, unpleasant jobs, such as underground mining or heavy
construction, to work long hours with great intensity, or to moonlight will tend
to earn more.
Individuals also differ in their willingness to assume risk. We refer here not
only to the race car driver or the professional boxer but also to the entrepreneur.
Although many entrepreneurs fail, many of those who develop successful new
products or services realize very substantial incomes. That contributes to income
inequality.

Unequal Distribution of Wealth

Income is a flow; it represents a stream of wage and salary earnings, along with rent,
interest, and profits, as depicted in Chapter 2’s circular flow diagram. In contrast,
wealth is a stock, reflecting at a particular moment the financial and real assets an
individual has accumulated over time. A retired person may have very little income
and yet own a home, mutual fund shares, and a pension plan that add up to con-
siderable wealth. A new university graduate may be earning a substantial income
as an accountant, middle manager, or engineer but have yet to accumulate signifi-
cant wealth.
The ownership of wealth in Canada is more unequal than the distribution of
income. This inequality of wealth leads to inequality in rent, interest, and dividends,
which in turn contributes to income inequality. Those who own more machinery,
real estate, farmland, stocks and bonds, and savings accounts obviously receive
greater income from that ownership than people with less or no such wealth.

Market Power
The ability to “rig the market” on your own behalf also contributes to income
inequality. For example, in resource markets certain unions and professional groups
have adopted policies that limit the supply of their services, thereby boosting the
incomes of those on the inside. Also, legislation that requires occupational licensing
for, say, doctors, dentists, and lawyers can bestow market power that favours the
licensed groups. In product markets, rigging the market means gaining or enhanc-
ing monopoly power, which results in greater profit and thus greater income to the
firms’ owners.

Luck, Connections, and Misfortune

Other forces also play a role in producing income inequality. Luck and being in
the right place at the right time have helped individuals to stumble into for-
tunes. Discovering oil on a ranch, owning land along a proposed highway inter-
change, and hiring the right press agent have accounted for some high incomes.
Personal contacts and political connections are other potential routes to attaining
high income.
In contrast, economic misfortunes such as prolonged illness, serious accident,
death of the family breadwinner, or unemployment may plunge a family into the
low range of income. The burden of such misfortune is borne very unevenly by the
population and thus contributes to income inequality. (Key Question 4)
 chapter seventeen • income inequality and poverty 443

● Data reveal considerable income inequality in
Canada; in 1997 the richest fifth of all families
receive 41.4 percent of after-tax income, and
the poorest fifth receives 5.5 percent.
● The Lorenz curve depicts income inequality
graphically by comparing percentages of total
families and percentages of total income.
● The distribution of income is less unequal over
longer periods.
● Government taxes and transfers significantly
reduce income inequality by redistributing
income from higher-income groups to lower-
income groups; the bulk of this redistribution
results from transfer payments.
● Differences in ability, education and training,
tastes for market work versus nonmarket activ-
ities, property ownership, and market power—
along with discrimination and luck—help explain
income inequality.

Trends in Income Inequality

Over a period of years economic growth has raised incomes in Canada: In absolute
dollar amounts, the entire distribution of income has been moving upward. But
incomes may move up in absolute terms while leaving the relative distribution of
income less equal, or unchanged. Table 17-2 shows the relative distribution of per-
sonal income over time. Recall that personal income is before tax and includes cash
transfers but not noncash transfers. As you can see, the distribution of income in
<www.ccsd.ca/ Canada has remained remarkably constant over the past 50 years.
perception/insite7.htm>
Who benefits from
Global Perspective 17.1 compares inequality in Canada (here by individuals, not
Canada’s income by families) with that in several other nations. Income inequality tends to be high-
security programs? est in developing nations.

Causes of Growing Inequality

Economists suggest several major explanations for the rise of income inequality of
the past three decades.

GREATER DEMAND FOR HIGHLY SKILLED WORKERS

Perhaps the most significant contributor to the growing income inequality has been
an increasing demand by many firms for workers who are highly skilled and well
educated. Several industries requiring highly skilled workers have either recently
emerged or expanded greatly, such as the computer software, business consulting,
biotechnology, health care, and Internet industries. Because highly skilled workers
remain relatively scarce, their wages have been bid up. Consequently, the wage dif-
ferences between them and less-skilled workers have increased.
The rising demand for skill has also evidenced itself in rapidly rising pay for
CEOs (chief executive officers), sizable increases in income from stock options, sub-
stantial increases in incomes of professional athletes and entertainers, and huge for-
tunes for successful entrepreneurs. This growth of “superstar” pay has also
contributed to rising income inequality.

DEMOGRAPHIC CHANGES
The entrance of large numbers of less-experienced and less-skilled baby boomers
into the labour force during the 1970s and 1980s may have contributed to greater
444 Part Three • Microeconomics of Resource Markets

17.1

Percentage of Total Income Earned by

Percentage of total Top Fifth of Income Receivers
income received by 30 40 50 60 70
top one-fifth of
South Africa
income receivers,
selected nations Brazil
Guatemala
The share of income going
to the highest 20 percent Mexico
of income receivers varies United States
among nations. Frequently, Canada
income is less equally France
shared in poor nations Italy
than in rich ones.
Norway

Source: World Development Report, 2000, pp. 238–239.

income inequality in those two decades. Because younger workers tend to earn less
income than older workers, their growing numbers contributed to income inequal-
ity. There has also been a growing tendency for men and women with high earnings
potential to marry each other, thus increasing family income among the highest-
income quintiles. Finally, the number of families headed by single or divorced
women has increased greatly. That trend has increased income inequality because
such families lack a second major wage earner, and also because the poverty rate for
female-headed households is very high.

INTERNATIONAL TRADE, IMMIGRATION, AND DECLINE IN UNIONISM

Other factors are likely at work. Stronger international competition from imports
has reduced the demand for and employment of less-skilled (but highly paid)
workers in such industries as the automobile and steel industries. The decline in
such jobs has reduced the average wage for less-skilled workers. It also has swelled
the ranks of workers in already low-paying industries, placing further downward
pressure on wages there. Similarly, the transfer of jobs to lower-wage workers in
developing countries exerts downward wage pressure on less-skilled workers in
Canada. Also, an upsurge in immigration of unskilled workers increases the num-
ber of low-income families in Canada. Finally, the decline in unionism in Canada
undoubtedly contributes to wage inequality, since unions tend to equalize pay
within firms and industries.
Two cautions are in order: First, when we note growing income inequality, we are
not saying that the rich are getting richer and the poor are getting poorer in terms
of absolute income. Both the rich and the poor are experiencing rises in real income.
Rather, what has happened is that, while incomes have risen in all quintiles, income
growth was fastest in the top quintile. Second, increased income inequality is not
solely a Canadian phenomenon. The recent move toward greater inequality has also
occurred in several other industrially advanced nations.
 chapter seventeen • income inequality and poverty 445

Equality versus Efficiency

The main policy issue concerning income inequality is how much is necessary and
justified. While no general agreement exists on the justifiable amount, we can gain
insight by exploring the cases for and against greater inequality.

The Case for Equality: Maximizing Total Utility

The basic argument for an equal distribution of income is that income equality max-
imizes the total consumer satisfaction (utility) from any particular level of output
and income. The rationale for this argument is shown in Figure 17-2, in which we
assume that the money incomes of two individuals, Anderson and Brooks, are sub-
ject to diminishing marginal utility. In any period, income receivers spend the first
dollars received on the products they value most—products whose marginal utility
is high. As their most pressing wants become satisfied, consumers then spend addi-
tional dollars of income on less important, lower-marginal-utility goods. The iden-
tical diminishing-marginal-utility-from-income curves (MUA and MUB in the figure)
reflect the assumption that Anderson and Brooks have the same capacity to derive
utility from income.
Now suppose $10,000 worth of income (output) is to be distributed between
Anderson and Brooks. According to proponents of income equality, the optimal dis-
tribution is an equal distribution, which causes the marginal utility of the last dol-
lar spent to be the same for both persons. We can prove this by demonstrating that
if the income distribution is initially unequal, then distributing income more equally
can increase the combined utility of the two individuals.

FIGURE 17-2 THE UTILITY-MAXIMIZING DISTRIBUTION OF INCOME

Marginal utility

Marginal utility

a Utility gain
(entire grey area) Utility loss
(entire pale grey area)
a′ b′
MUA b MUB
G
L

0 $2500 $5000 0 $5000 $7500

Income Income
With identical marginal-utility-of-income curves MUA and MUB, Anderson and Brooks will maximize their combined utility when
any amount of income (say, $10,000) is equally distributed. If income is unequally distributed (say, $2500 to Anderson and $7500
to Brooks), the marginal utility derived from the last dollar will be greater for Anderson than for Brooks, and a redistribution
toward equality will result in a net increase in total utility. The utility gained by equalizing income at $5000 each, shown by the
full area G below curve MUA in panel (a), exceeds the utility lost, indicated by the full area L below curve MUB in panel (b).
446 Part Three • Microeconomics of Resource Markets

Suppose that the $10,000 of income initially is distributed unequally, with Ander-
son getting $2500 and Brooks $7500. The marginal utility, a, from the last dollar
received by Anderson is high, and the marginal utility, b, from Brooks’s last dollar
of income is low. If a single dollar of income is shifted from Brooks to Anderson—
that is, toward greater equality—then Anderson’s utility increases by a and Brooks’s
utility decreases by b. The combined utility then increases by a minus b (Anderson’s
large gain minus Brooks’s small loss). The transfer of another dollar from Brooks to
Anderson again increases their combined utility, this time by a slightly smaller
amount. Continued transfer of dollars from Brooks to Anderson increases their
combined utility until the income is evenly distributed and both receive $5000. At
that time their marginal utilities from the last dollar of income are equal at (a⬘ and
b⬘), and any further income redistribution beyond the $2500 already transferred
would begin to create inequality and decrease their combined utility.
The area under the MU curve, and to the left of the individual’s particular level
of income, represents the total utility of that income. Therefore, as a result of the
transfer of the $2500, Anderson has gained utility represented by the full area G
below the curve MUA, and Brooks has lost utility represented by the full area L
below the curve MUB. Area G is obviously greater than area L, so income equality
yields greater combined total utility than income inequality does.

The Case for Inequality: Incentives and Efficiency

Although the logic of the argument for equality is sound, critics attack its funda-
The Influence
of Incentives mental assumption that there is some fixed amount of output produced and there-
fore income to be distributed. Critics of income equality argue that the way in which
income is distributed is an important determinant of the amount of output or income that
is produced and is available for distribution.
Suppose once again in Figure 17-2 that Anderson earns $2500 and Brooks earns
$7500. In moving toward equality, society (the government) must tax away some of
Brooks’s income and transfer it to Anderson. This tax-and-transfer process dimin-
ishes the income rewards of high-income Brooks and raises the income rewards of
low-income Anderson; in so doing, it reduces the incentives of both to earn high
incomes. Why should high-income Brooks work hard, save, invest, or undertake
entrepreneurial risks when the rewards from such activities will be reduced by tax-
ation? Why should low-income Anderson be motivated to increase his income
through market activities when the government stands ready to transfer income to
him? Taxes are a reduction in the rewards from increased productive effort; redis-
tribution through transfers is a reward for diminished effort.
In the extreme, imagine a situation in which the government levies a 100 percent
tax on income and distributes the tax revenue equally to its citizenry. Why would
anyone work hard? Why would anyone work at all? Why would anyone assume
business risk? Or why would anyone save (forgo current consumption) in order to
invest? The economic incentives to get ahead would be removed, greatly reducing
society’s total production and income. In other words, the way the income pie is dis-
tradeoff tributed affects the size of that pie. The basic argument for income inequality is that
between inequality is essential to maintain incentives to produce output and income—that
equality and is, to get the pie baked year after year.
efficiency
The decrease in
economic efficiency The Equality–Efficiency Tradeoff
that may accom-
pany a decrease in The essence of this income equality–inequality debate is that there is a fundamen-
income inequality. tal tradeoff between equality and efficiency. The problem for a society that is
 chapter seventeen • income inequality and poverty 447

inclined toward equality is to redistribute income in a way that minimizes the

adverse effects on economic efficiency. Consider this leaky-bucket analogy: Assume
that society agrees to shift income from the rich to the poor, but the money must be
carried from affluent to indigent in a leaky bucket. The leak represents an efficiency
loss—the loss of output and income—caused by the harmful effects of the redistri-
bution on incentives to work, to save and invest, and to accept entrepreneurial risk.
This leak also reflects the fact that resources must be diverted to the bureaucracies
that administer the redistribution system.
How much leakage will society accept while continuing to agree to the redistri-
bution? If cutting the income pie into more equal slices shrinks the pie, what
amount of shrinkage will society tolerate? Is a loss of one cent on each redistributed
dollar acceptable? 5 cents? 25 cents? 50 cents? This is the basic question in any
debate over the ideal size of a nation’s income-maintenance programs.

The Economics of Poverty

We next turn from the larger issue of income distribution to the more specific issue
of very low income, or poverty. A society with a high degree of income inequality
can have either a high, moderate, or low amount of poverty. We need to learn about
the extent of poverty in Canada, the characteristics of the poor, and the programs
designed to reduce poverty.

Definition of Poverty
Poverty does not lend itself to precise definition, but it helps to distinguish between
absolute absolute and relative poverty. Absolute poverty occurs when the basic material
poverty A needs—food, clothing, and shelter—of an individual or a family are not met. Rela-
situation in which tive poverty refers to an individual’s or a family’s low income relative to others in
the basic material
needs of an indi-
society. While a family’s basic material needs may be met, it would still be consid-
vidual or a family ered poor if its income relative to others is much lower.
(food, clothing, While it is possible to eradicate absolute poverty, relative poverty will probably
shelter) are not met. always be around, at least in a market economy, where some individuals are able to
earn much more than others.
relative A family’s needs have many determinants: its size, its health, the ages of its
poverty A situ-
ation in which an members, and so forth. Its means include currently earned income, transfer pay-
individual’s or a ments, past savings, property owned, and so on. Statistics Canada uses a (revised
family’s income 1992) low income cut-off: families that spend 54.7 percent or more of their income
is low relative to on food, shelter, and clothing are considered to be below the cut-off. In 1997, 14.0
others in society.
percent of families and 39.6 percent of unattached individuals were considered to
be living in poverty in Canada.

Who Are the Poor?

<www.napo-onap.ca/ Unfortunately for purposes of public policy, the poor are heterogeneous: they can
nf-figur2.htm> be found in all geographic regions; they are whites, non-whites, and Native peoples;
Facts and figures they include large numbers of both rural and urban people; they are both old and
about poverty in
Canada
young.
Yet, despite this pervasiveness, poverty is far from randomly distributed, as Table
17-3 demonstrates. An aging widow with four years of schooling living in an
Atlantic town and prevented from seeking paid work by her four under-16 children
still at home—well, she is likely to be poor. When her children have left home and
448 Part Three • Microeconomics of Resource Markets

TABLE 17-3 INCIDENCE OF LOW INCOME BY SELECTED

CHARACTERISTICS, 1997
ESTIMATED PERCENTAGE
BELOW LOW INCOME CUT-OFF*
Families Unattached Individuals

All families and unattached individuals 14.0 39.6

By region: Atlantic provinces 14.8 41.6
Quebec 16.4 47.4
By age of household head: 24 years and over 42.8 60.7
25 to 34 years 18.7 30.9
65 and over 6.8 45.0
By sex of household head—female 40.2 44.3
By marital status of household head: neither married nor single† 29.0 40.6
By weeks worked: none 28.1 57.6
1 to 9 weeks 43.7 85.2
10 to 19 weeks 33.4 71.1
20 to 29 weeks 27.6 52.2
30 to 39 weeks 20.3 44.0
40 to 48 weeks 14.4 37.1
49 to 52 weeks 5.9 17.2
By education of household head: 0 to 8 years of school 18.4 58.7
some secondary 19.0 48.8
By origin of household head: Canadian born 12.4 38.5
non-Canadian born 19.9 45.2
By number of children under 16 years: none 9.7 39.6
1 19.5 —
2 18.0 —
3 or more 24.9 —
Source: Statistics Canada, Income Distribution by Size in Canada, 1997 (Ottawa, 1998), Table 67.
*As defined on page 42 of the source, families that spent 54.7 percent or more of their income on food, shelter, and clothing were con-
sidered to be in straitened circumstances and, therefore, below the 1992 LICO. According to this criterion, it is estimated that 5.2 mil-
lion people were below the LICO in 1997, which represents 17.5 percent of the covered population (of whom 1,397,000 were children).
†
Divorced, separated, or widowed.

she is over 70, her fortunes look no brighter. The strong correlation shown in Table
17-3 between working few weeks in the year and being poor is expected. However,
note that 5.9 percent of families and 17.2 percent of unattached individuals who
worked 49 to 52 weeks were still poor.
The high poverty rate for children is especially disturbing because poverty tends
to breed poverty. Poor children are at greater risk for a range of long-term problems,
including poor health and inadequate education, crime, drugs, and teenage preg-
nancy. Many of today’s impoverished will reach adulthood unhealthy, illiterate, and
unable to earn above-poverty incomes.
From our discussion of income mobility, we know that there is considerable
movement out of poverty. Only slightly more than half of those who are in poverty
 chapter seventeen • income inequality and poverty 449

canada pen- one year will remain below the poverty line the next year. However, poverty is
sion plan much more persistent for some groups, in particular families headed by women,
(cpp) A national those with little education and few labour market skills, and those who are dys-
retirement plan
funded by obligatory
functional because of drugs, alcoholism, or mental illness.
employer and em-
ployee contributions. The Invisible Poor
old age The facts and figures on the extent and character of poverty may be difficult to
security
(oas) A pension accept. After all, ours is an affluent society. How do we reconcile the depressing sta-
paid on application tistics on poverty with everyday observations of abundance? The answer lies
at age 65 to every- mainly in the fact that much Canadian poverty is hidden; it is largely invisible.
one resident in There are three reasons for this invisibility. First, a sizable proportion of the people
Canada for at least
in the poverty pool change from year to year. Research has shown that as many as one-
10 years immediately
before turning 65. half of those in poverty are poor for only one or two years before successfully climbing
out of poverty. Many of these people are not visible as being permanently down-
trodden and needy. Second, the “permanently poor” are increasingly isolated geo-
graphically. Poverty persists in depressed areas of large cities and is not readily visible
from the expressway or commuter train. Similarly, rural poverty and the chronically
<www.statcan.ca/
Daily/English/000306/
depressed areas of eastern Quebec and the Atlantic provinces are also off the beaten
d000306a.htm> path. Third, and perhaps most important, the poor are politically invisible. They often
Poverty and the elderly do not have interest groups fighting the various levels of governments for their rights.

The Income Maintenance System

The existence of a wide vari-
The Role of
TABLE 17-4 ESTIMATED FEDERAL Governments ety of income-maintenance
GOVERNMENT programs is evidence that
TRANSFER PAYMENTS, alleviation of poverty has
2001–2002 been accepted as a legitimate goal of public
policy. In recent years, income-maintenance
Estimated expenditures*, programs have involved substantial monetary
Program millions of dollars
outlays and large numbers of beneficiaries.
Major transfers to other levels of government About one-half of the federal government’s
Fiscal Equalization 10,479 2001–02 expenditures will be transfer pay-
Canada Health ad Social Transfers 17,300 ments. The government estimates these $83 mil-
Territorial governments 1,539 lion of expenditures will be disbursed as shown
Alternative payments for standing programs (2,400) in Table 17-4. It should be noted, however, that
Other (500) the bulk of these transfers go to the non-poor,
Subtotal 26,458 and only a few of these programs are specifi-
Major transfers to persons cally targeted at the poor.
Elderly Benefits 25,181 In addition to all these programs, there is the
Employment Insurance 12,247 Canada Pension Plan (CPP)—funded by oblig-
Subtotal 37,428
atory employee and employer contributions.1 It
Other transfer payments and subsidies 18,996
increases each year by the percentage increase
Total transfer payments 82,882 in the cost of living in the previous year.
Source: Treasury Board Secretariat 2001–2002 Estimates, Part I: The Old Age Security (OAS) pension is paid
The Government Expenditure Plan and Part II: The Main Estimates on application at age 65 to everyone resident in
(Ottawa: Supply and Services Canada, 2001), <www.tbs-sct.gc.ca/
tb/estimate/EstimE.html>. Reproduced with the permission of the Canada for at least 10 years immediately before
Minister of Public Works and Government Services Canada, 2001.
*Fiscal year ending March 31, 2002
Visit www.mcgrawhill.ca/college/mcconnell9 for data update. 1
The Quebec Pension Plan, for residents of that province,
is similar.
450 Part Three • Microeconomics of Resource Markets

guaranteed turning 65. The Guaranteed Income Supplement (GIS) is paid on application, sub-
income ject to a means test, to those receiving the OAS pension who have an income below
supplement a certain level. Considerably more than half of Canadians over 65 draw the GIS.
(gis) Money paid Both the OAS pension and the GIS are increased every three months by the per-
on application, sub-
ject to a means test, centage increase in the cost of living in the previous three months.
to those receiving Employment insurance (EI) was started in 1940 to insure workers against the
an OAS pension hazards of losing their jobs. Certainly it has lessened the misery of the very large
who have an income number of the involuntarily unemployed during recessionary periods. In the early
below a certain level.
1970s, employment insurance benefits were greatly increased so a positive incen-
employment tive was created for marginal workers to enter the labour force, not to work, but to
insurance qualify for benefits. In 1977, benefits were decreased slightly while qualifying for
(ei) A program them was made more difficult. By the early 1990s the federal government had tight-
that insures workers ened the rules to qualify for EI, as it coped with mounting deficits. By mid-2000
against the hazards
of losing their jobs.
the number of persons receiving EI had fallen significantly, partly as a result of a
healthy economy.

● The fundamental argument for income equality
is that it maximizes total utility by equalizing the
marginal utility of the last dollar of income re-
ceived by all people.
● The basic argument for income inequality is
that it is necessary as an economic incentive for
production.
● By government standards, more than five mil-
lion Canadians, or 17.5 percent of the popula-
tion, live in poverty.
● The Canadian income maintenance system in-
cludes both social insurance programs and pub-
lic assistance (welfare) programs.

Welfare: Goals and Conflicts

An ideal public assistance (welfare) program should simultaneously achieve three
Facing
Tradeoffs goals. First, the plan should be effective in getting individuals and families out of
poverty. Second, it should provide adequate incentives for able-bodied, nonretired
people to work. Third, the plan’s cost should be reasonable. Unfortunately, these
three goals conflict, causing tradeoffs and necessitating compromises. To under-
stand this, consider the three hypothetical welfare plans shown in Table 17-5.

Common Features
We first examine the two common elements in each of the three plans (and in real-
world public assistance plans). First, there is a minimum annual income that govern-
ment will provide if the family has no earned income. Second, each plan has a
benefit-reduction rate, which is the rate at which benefits are reduced or lost as a result
of earned income.
Consider plan 1. The minimum annual income provided by government is $8,000,
and the benefit-reduction rate is 50 percent. If a family earns no income, it will receive
cash transfer payments totalling $8,000. If it earns $4,000, it will lose $2,000 ($4,000
of earnings times the 50 percent benefit-reduction rate) of transfer payments; its total
income will then be $10,000 (= $4,000 of earnings plus $6,000 of transfer payments).
If $8,000 is earned, transfer payments will fall to $4,000, and so on. Note that at an
 chapter seventeen • income inequality and poverty 451

TABLE 17-5 TRADEOFFS AMONG GOALS: THREE PUBLIC

ASSISTANCE PLANS
Plan 1 ($8,000 minimum income Plan 2 ($8,000 minimum income Plan 3 ($12,000 minimum income
and 50% benefit-reduction rate) and 25% benefit-reduction rate) and 50% benefit-reduction rate)

Earned Transfer Total Earned Transfer Total Earned Transfer Total

income payment income income payment income income payment income

$ 0 $8,000 $ 8,000 $ 0 $8,000 $ 8,000 $ 0 $12,000 $12,000

4,000 6,000 10,000 8,000 6,000 14,000 8,000 8,000 16,000
8,000 4,000 12,000 16,000 4,000 20,000 16,000 4,000 20,000
12,000 2,000 14,000 24,000 2,000 26,000 24,000* 12,000 24,000
16,000* 0 16,000 32,000* 0 32,000
*Indicates break-even income. Determined by dividing the minimum income by the benefit-reduction rate.

income of $16,000, transfer payments are zero. The level of earned income at which
the transfer payments disappear is called the break-even income.
We might criticize plan 1 on the grounds that a 50 percent benefit-reduction rate
is too high and therefore does not provide sufficient incentives to work. As earned
income increases, the loss of transfer payments constitutes a tax on earnings. Some
people may choose not to work when they lose 50 cents of each extra dollar earned.
Thus in plan 2 the $8,000 minimum income is retained, but the benefit-reduction
rate is reduced to 25 percent. But note that the break-even level of income increases
to $32,000, so many more families would now qualify for transfer payments. Fur-
thermore, a family with any earned income under $32,000 will receive a larger total
transfer payment. For both reasons, a reduction of the benefit–loss rate to enhance
work incentives will raise the cost of the income-maintenance plan.
After examining plans 1 and 2, we might argue that the $8,000 minimum annual
income is too low—it does not get families out of poverty. Plan 3 raises the mini-
mum income to $12,000 and retains the 50 percent benefit-reduction rate of plan 1.
While plan 3 does a better job of raising the incomes of the poor, it too yields a
higher break-even income than plan 1 and therefore will be more costly. Also, if the
$12,000 income guarantee of plan 3 were coupled with plan 2’s 25 percent benefit-
reduction rate to strengthen work incentives, the break-even income level would
shoot up to $48,000 and add even more to the costs of the public assistance program.

Conflicts among Goals

<www.un.org/esa/ Clearly, the goals of eliminating poverty, maintaining work incentives, and holding
socdev/poverty.htm> down program costs are in conflict.
UN declares 1997–2006 Plan 1, with a low minimum income and a high benefit-reduction rate, keeps cost
the Decade for the
Eradication of Poverty
down. But the low minimum income means that this plan is not very effective in
eliminating poverty, and the high benefit-reduction rate weakens work incentives.
In comparison, plan 2 has a lower benefit-reduction rate and therefore stronger
work incentives. But it is more costly because it sets a higher break-even income and
therefore pays benefits to more families.
Compared with plan 1, plan 3 has a higher minimum income and is more effec-
tive in eliminating poverty. While work incentives are the same as those in plan 1, the
higher guaranteed income in plan 3 makes the plan more costly. (Key Question 9)
452 Part Three • Microeconomics of Resource Markets
Poor people in 60 countries were
asked to analyze and share their
ideas of well-being (a good ex-
perience of life) and “ill-being”
(a bad experience of life).
Well-being was variously de-
scribed as happiness, harmony,
peace, freedom from anxiety,
and peace of mind. In Russia
people say, “Well-being is a life
free from daily worries about
lack of money.” In Bangladesh,
“to have a life free from anxi-
ety.” In Brazil, “not having to go
through so many rough spots.”
People describe ill-being as
lack of material things, as bad
experiences, and as bad feel-
ings about oneself. A group of
young men in Jamaica ranks
lack of self-confidence as the
second biggest impact of
poverty: “Poverty means we
don’t believe in [ourselves], we
hardly travel out of the commu-
nity—so frustrated, just locked
up in a house all day.”
Universal Problems
Although the nature of ill-being
and poverty varies among loca-
tions and people—something
that policy responses must take
into account—there is a striking
commonality across countries.
Not surprising, material well-
POVERTY IN THE VOICES OF
POOR PEOPLE
While statistics tell us much about poverty and inequality,
the statements below attest to the human suffering
caused by insufficient material means in many nations.
being turns out to be very im-
portant. Lack of food, shelter,
and clothing is mentioned every-
where as critical. In Kenya a man
says: “Don’t ask me what
poverty is because you have met
it outside my house. Look at the
house and count the number of
holes. Look at my utensils and
the clothes I am wearing. Look at
everything and write what you
see. What you see is poverty.”
Alongside the material, phys-
ical well-being features promi-
nently in the characterizations of
poverty. And the two meld to-
gether when lack of food leads
to ill health—or when ill health
leads to an inability to earn in-
come. People speak about the
importance of looking well fed.
In Ethiopia poor people say, “We
are skinny,” “We are deprived
and pale,” and speak of life that
“makes you older than your
age.”
More Than Material Goods
Security of income is also
closely tied to health. But inse-
curity extends beyond ill health.
Crime and violence are often
mentioned by poor people. In
Ethiopia women say, “We live
hour to hour,” worrying about
whether it will rain. An Argen-
tine says, “You have work, and
you are fine. If not, you starve.
That’s how it is.” Two social as-
pects of ill-being and poverty
also emerged. For many poor
people, well-being means the
freedom of choice and action
and the power to control one’s
life. A young woman in Jamaica
says that poverty is “like living in
jail, living in bondage, waiting to
be free.”
Linked to these feelings are
definitions of well-being as so-
cial well-being and comments
on the stigma of poverty. As an
old woman in Bulgaria says, “to
be well means to see your
grandchildren happy and well
dressed and to know that your
children have settled down; to
be able to give them food and
money whenever they come to
see you, and not to ask them
for help and money.” A Somali
proverb captures the other side:
“Prolonged sickness and per-
sistent poverty cause people to
hate you.”
Source: World Development Report
2000–2001, “Introduction,”(Oxford
University Press, New York, 2000),
<www.worldbank.org/poverty/wdr
poverty/report/ch1.pdf>.
 chapter seventeen • income inequality and poverty 453

chapter summary
1. The distribution of income in Canada reflects
considerable inequality. After taxes, the top
20 percent of families earn 41.4 percent of
total income, while the bottom 20 percent
earn only 5.5 percent.
2. The Lorenz curve shows the percentage of
total income received by each percentage of
families. The extent of the gap between the
Lorenz curve and a line of total equality illus-
trates the degree of income inequality.
3. Recognizing that the positions of individual
families in the distribution of income change
over time and incorporating the effects of
noncash transfers and taxes would reveal less
income inequality than do standard census
data. Government transfers (cash and non-
cash) greatly lessen the degree of income
inequality; taxes also reduce inequality but
not nearly as much as transfers.
4. Absolute poverty occurs when the basic
material needs are not met. Relative poverty
refers to an individual’s or a family’s low
income relative to the rest of society. Absolute
poverty can be eradicated, but relative
poverty is much more difficult to resolve.
5. Causes of income inequality include differ-
ences in abilities, education and training, and
job tastes, along with discrimination, inequal-
ity in the distribution of wealth, and an un-
equal distribution of market power.
6. The basic argument for income equality is
that it maximizes consumer satisfaction (total
utility) from a particular level of total income.
The main argument for income inequality is
that it provides the incentives to work, invest,
and assume risk; it is necessary for the pro-
duction of output that, in turn, creates income
that is then available for distribution.
7. Current statistics suggest that about 17.5 per-
cent of the country lives in poverty. Poverty is
concentrated among the poorly educated, the
aged, and families headed by women.
8. Our present income maintenance system is
made up of social insurance programs
(Canada Pension Plan and employment insur-
ance benefits), universal programs (Old Age
Security Pension), and public assistance or
welfare programs.
9. Public assistance programs (welfare) are
difficult to design because their goals of
reducing property, maintaining work incen-
tives, and holding down program costs often
conflict.

terms and concepts

income inequality, p. 438
Lorenz curve, p. 438
income mobility, p. 440
noncash transfers, p. 440
tradeoff between equality and
efficiency, p. 446
absolute poverty, p. 447 Guaranteed Income
relative poverty, p. 447 Supplement (GIS), p. 450
Canada Pension Plan (CPP), employment insurance, p. 450
p. 449
Old Age Security (OAS),
p. 449

study questions
1. Using quintiles, briefly summarize the degree
of income inequality in Canada.
2. KEY QESTION Assume Syed, Beth,
Sabine, David, and Mikkel receive incomes
of $500, $250, $125, $75, and $50 respec-
tively. Construct and interpret a Lorenz curve
for this five-person economy. What percent-
age of total income is received by the richest
quintile and by the poorest quintile?
3. Why is the lifetime distribution of income
more equal than the distribution in any spe-
cific year?
4. KEY QUESTION Briefly discuss the
major causes of income inequality. With
respect to income inequality, is there any dif-
ference between inheriting property and
inheriting a high IQ? Explain.
5. Use the leaky-bucket analogy to discuss the
equality–efficiency tradeoff.
6. Should a nation’s income be distributed to
its members according to their contributions
to the production of that total income or
according to the members’ needs? Should
society attempt to equalize income or
454 Part Three • Microeconomics of Resource Markets

economic opportunities? Are the issues of
equity and equality in the distribution of in-
come synonymous? To what degree, if any,
is income inequality equitable?
7. Analyze in detail: “There need be no tradeoff
between equality and efficiency. An efficient
economy that yields an income distribution
many regard as unfair may cause those with
meagre income rewards to become discour-
aged and stop trying. Hence, efficiency is un-
dermined. A fairer distribution of rewards
may generate a higher average productive
effort on the part of the population, thereby
enhancing efficiency. If people think they are
playing a fair economic game and this belief
causes them to try harder, an economy with
an equitable income distribution may be effi-
cient as well.”
8. Comment on or explain:
a. “To endow everyone with equal income
will certainly make for very unequal
enjoyment and satisfaction.”
b. “Equality is a superior good: the richer we
become, the more of it we can afford.”
c. “The mob goes in search of bread, and
the means it employs is generally to wreck
the bakeries.”
d. “Some freedoms may be more important
in the long run than freedom from want
on the part of every individual.”
e. “Capitalism and democracy are really a
most improbable mixture. Maybe that
is why they need each other—to put
some rationality into equality and some
humanity into efficiency.”
f. “The incentives created by the attempt to
bring about a more equal distribution of
income are in conflict with the incentives
needed to generate increased income.”
9. KEY QUESTION The following table
contains three hypothetical public assistance
plans.
a. Determine the minimum income, the
benefit-reduction rate, and the break-even
income for each plan.
b. Which plan is the most costly? the least
costly? Which plan is the most effective
in reducing poverty? the least effective?
Which plan embodies the strongest dis-
incentive to work? the weakest disincen-
tive to work?
c. Use your answers in part b to explain the
following statement: “The dilemma of
public assistance is that you cannot bring
families up to the poverty level and
simultaneously preserve work incentives
and minimize program costs.”
10. (The Last Word) How do poor people
describe “well being” and “ill-being”?

Plan One Plan Two Plan Three

Earned Transfer Total Earned Transfer Total Earned Transfer Total

income payment income income payment income income payment income

$ 0 $4,000 $4,000 $ 0 $4,000 $ 4,000 $ 0 $8,000 $ 8,000

2,000 3,000 5,000 4,000 3,000 7,000 4,000 6,000 10,000
4,000 2,000 6,000 8,000 2,000 10,000 8,000 4,000 12,000
6,000 1,000 7,000 12,000 1,000 13,000 12,000 2,000 14,000

internet application questions

1. Statistics Canada at <www.statcan.ca/english/
Pgdb/People/Famili.htm#inc> compiles infor-
mation about low income in Canada. Use
that site to answer the following questions:
a. Is the percentage of the population living
below Statistics Canada’s low income cut-
off higher or lower than in the previous
year reported? Compared to a decade
earlier?
b. Is the poverty rate (in percent) higher or
lower than the previous year for the gen-
eral population and children under 18
and the elderly?
 EIGHTEEN

Government
and Market
Failure

T
he economic activities of government

affect your well-being every day. If you

drive to work or to school, you are using

publicly provided highways and streets. If

IN THIS CHAPTER
Y OU WILL LEARN: you attend a college or university, taxpayers

To distinguish between a subsidize your education. When you receive

public and private good.
• a cheque from your job, you see deductions
How to determine the optimal
amount of a public good. for income taxes and social insurance taxes.
•
Government antipollution laws affect the air
The nature of externalities and
the ways of dealing with them. you breathe. Laws requiring seat belts and
•
About information failures. motorcycle helmets and the sprinkler system

in university dormitories are all government

mandates.
 chapter eighteen • government and market failure 457

In this chapter we examine market failure—a circumstance in which private markets

do not bring about the allocation of resources that best satisfies society’s wants.
Where private markets fail, an economic role for government may arise. In this
chapter we examine how government responds to three types of market failure:
public goods, externalities, and information asymmetries. Our discussion of exter-
nalities in turn opens the way for a discussion of pollution and pollution policies.
In Chapter 19 our discussion of the microeconomics of government continues
with an analysis of potential government inefficiencies—called government failure—
and the economics of taxation.

Public Goods
Recall from Chapter 4 that a private good is divisible because it comes in units small
The Role of
Governments enough for individual buyers to afford. It is also subject to the exclusion principle: peo-
ple unwilling or unable to pay for the product are barred from obtaining its benefits.
Because of these characteristics, the demand for a private good gets expressed in the
marketplace, and profit-seeking suppliers satisfy that demand. In contrast, a public
good is indivisible and does not fit the exclusion principle. Once a producer has pro-
vided a public good, it cannot bar those who don’t pay from obtaining the benefits.
Consequently, the demand for the good is understated in the marketplace, and firms
thus lack a profit incentive to offer it for sale. If the good is to exist at all, government
will have to provide it. Two simple examples will help clarify these ideas.
The market demand for a private good is the horizontal summation of the
demand curves representing all individual buyers (review Table 3-2 and Figure 3-
2). Suppose just two people in society enjoy hot dogs, which cost $.80 each to pro-
duce. If Adams wants to buy three hot dogs at $1 each and Benson wants to buy two
hot dogs at that same price, the market demand curve will reflect that five hot dogs
are demanded at a $1 price. A seller charging $1 for each hot dog can gain $5 of rev-
enue and earn $1 of profit ($5 of total revenue minus $4 of cost).
The situation is different with public goods. Suppose an enterprising sculptor
creates a piece of art costing $600 and places it in the town square. Also suppose that
Adams gets $300 of enjoyment from the art and Benson gets $400. Sensing this
enjoyment and hoping to make a profit, the sculptor approaches Adams for a dona-
tion equal to his satisfaction. Adams falsely says that, unfortunately, he doesn’t
much like the piece. The sculptor then tries Benson, hoping to get $400 or so. Same
deal: Benson professes not to like the piece either. Adams and Benson have become
free riders. Although feeling a bit guilty, both reason that it makes no sense to pay for
something when you can receive the benefits without paying for them. The artist is
a quick learner; he vows never to try anything like that again.
Generalization: Because of the free-rider problem, the market demand for a pub-
lic good is nonexistent or significantly understated. Where a producer cannot
exclude those who do not pay from receiving the benefits from a good, it is difficult,
if not impossible, for the producer to profitably offer the good for sale. Government
will have to provide it.

Demand for Public Goods

If consumers need not reveal their true demand for a public good in the marketplace,
then how can the optimal amount of that good be determined? The answer is that the
<members.aol.com/
trajcom/private/
government has to try to estimate the demand for a public good through surveys or
commons.htm> public votes. Suppose Adams and Benson are the only two people in the society, and
The commons their marginal willingness to pay for a public good, this time national defence, is as
458 Part Four • Microeconomics of Government and Public Policy

shown in columns 1, 2, and 3 in Table 18-1. Econ-

TABLE 18-1 DEMAND FOR A omists might have discovered these schedules
PUBLIC GOOD, through a survey asking hypothetical questions
TWO INDIVIDUALS about how much each citizen was willing to pay
for various types and amounts of public goods
(1) (2) (3) (4)
Quantity Adams’s Benson’s Collective rather than go without them.
of public willingness willingness willingness Notice that the schedules in Table 18-1 are
good to pay (price) to pay (price) to pay (price) price–quantity schedules, implying that they
are demand schedules. Rather than depicting
1 $4 + $5 = $9 demand in the usual way—the quantity of a
2 3 + 4 = 7 product someone is willing to buy at each pos-
3 2 + 3 = 5 sible price—these schedules show the price
4 1 + 2 = 3 someone is willing to pay for the marginal unit
5 0 + 1 = 1 of each possible quantity. That is, Adams is will-
ing to pay $4 for the first unit of the public good,
$3 for the second, $2 for the third, and so on.
Suppose the government produces one unit of this public good. Because the
exclusion principle does not apply, Adams’s consumption of the good does not pre-
clude Benson from also consuming it, and vice versa. So both consume the good, and
neither volunteers to pay for it. But from Table 18-1 we can find the amount these two
people would be willing to pay, together, rather than do without this one unit of the
good. Columns 1 and 2 show that Adams would be willing to pay $4 for the first unit
of the public good; columns 1 and 3 show that Benson would be willing to pay $5 for
it. So the two people are jointly willing to pay $9 (= $4 + $5) for this unit.
For the second unit of the public good, the collective price they are willing to pay
is $7 (= $3 from Adams plus $4 from Benson); for the third unit they will pay $5
(= $2 plus $3); and so on. By finding the collective willingness to pay for each addi-
tional unit (column 4), we can construct a collective demand schedule (a willing-
ness-to-pay schedule) for the public good. Here, we are not adding the quantities
demanded at each possible price as when we determine the market demand for a
private good. Instead, we are adding the prices that people are willing to pay for the last
unit of the public good at each possible quantity demanded.
Figure 18-1 shows the same adding procedure graphically, using the data from Table
18-1. Note that we sum Adams’s and Benson’s willingness-to-pay curves vertically to
derive the collective willingness-to-pay curve (demand curve). For example, the height
of the collective demand curve Dc at two units of output, is $7, the sum of the amounts
that Adams and Benson are each willing to pay for the second unit (= $3 + $4). Likewise,
the height of the collective demand curve at four units of the public good is $3 (= $1 + $2).
What does it mean in Figure 18-1(a) that, for example, Adams is willing to pay $3
for the second unit of the public good? It means that Adams expects to receive $3 of
extra benefit or utility from that unit. And we know from the law of diminishing
marginal utility that successive units of any good yield less and less added benefit.
This is also true for public goods, explaining the downward slope of the willing-
ness-to-pay curves of both Adams and Benson, and of the collective demand curve.
These curves, in essence, are marginal-benefit curves. (Key Question 1)

Supply of Public Goods

The supply curve for any good, private or public, is its marginal-cost curve. Mar-
ginal cost rises as more of a good is produced. The reason is the law of diminishing
returns, which applies whether a society is making missiles (a public good) or
mufflers (a private good). In the short run, government has fixed resources (public
capital) with which to produce public goods such as national defence. As it adds
 chapter eighteen • government and market failure 459

FIGURE 18-1 THE OPTIMAL AMOUNT OF A PUBLIC GOOD

P
S The collective demand curve for a public good, as shown by
$9 Dc in panel (c), is found by summing vertically the individual
Optimal quantity willingness-to-pay curves D1 in panel (a) and D2 in panel (b)
7 of Adams and Benson, the only two people in the economy.
The supply curve of the public good represented in panel (c)
Collective
slopes upward and to the right, reflecting rising marginal
5
willingness costs. The optimal amount of the public good is three units,
to pay determined by the intersection of Dc and S. At that output,
3 marginal benefit (reflected in the collective demand curve
Dc) equals marginal cost (reflected in the supply curve S).
1
Dc
0 1 2 3 4 5 Q
(c) Collective demand and supply
P
$6
5 Benson's
4 willingness
to pay
3
2
1
D2
0 1 2 3 4 5 Q
(b) Benson

P
$6
5
Adams's
4 willingness
3 to pay
2
1
D1
0 1 2 3 4 5 Q
(a) Adams

more units of a variable resource (labour) to these fixed resources, total product
eventually rises at a diminishing rate. That means that marginal product falls and
marginal cost rises, explaining why curve S in Figure 18-1(c) slopes upward.

Optimal Quantity of a Public Good

We can now determine the optimal quantity of the public good. The collective
demand curve Dc in Figure 18-1(c) measures society’s marginal benefit of each unit
of this particular good. The supply curve S in that figure measures society’s mar-
ginal cost of each unit. The optimal quantity of this public good occurs where mar-
ginal benefit equals marginal cost, or where the two curves intersect. In Figure
18-1(c) that point is three units of the public good, where the collective willingness
to pay for the last (third) unit—the marginal benefit—just matches that unit’s mar-
ginal cost ($5 = $5). As we saw in Chapter 2, equating marginal benefit and marginal
cost efficiently allocates society’s scarce resources. (Key Question 2)
460 Part Four • Microeconomics of Government and Public Policy

Cost–Benefit Analysis
cost– The above example suggests a practical means, called cost–benefit analysis, for
benefit deciding whether to provide a particular public good and how much of it to
analysis provide. Like our example, cost–benefit analysis (or marginal benefit–marginal cost
Comparing the
marginal costs of a analysis) involves a comparison of marginal costs and marginal benefits.
government project
or program with the CONCEPT
marginal benefits to Suppose the federal government is contemplating a highway construction plan.
decide whether to
employ resources
Because the economy’s resources are limited, any decision to use more resources in
in that project or the public sector will mean fewer resources for the private sector. There will be both
program and to a cost and a benefit. The cost is the loss of satisfaction resulting from the accompa-
what extent. nying decline in the production of private goods; the benefit is the extra satisfaction
resulting from the output of more public goods. Should the needed resources be
shifted from the private to the public sector? The answer is yes if the benefit from
the extra public goods exceeds the cost that results from having fewer private
goods. The answer is no if the cost of the forgone private goods is greater than the
benefit associated with the extra public goods.
Cost–benefit analysis, however, can indicate more than whether a public program
is worth doing. It can also help the government decide on the extent to which a proj-
ect should be pursued. Real economic questions cannot usually be answered sim-
ply by yes or no but, rather, are matters of how much or how little.

ILLUSTRATION
Although a few private toll roads exist, highways clearly have public good charac-
teristics because the benefits are widely diffused and the exclusion principle is not
easily applied. Should the federal government expand the federal highway system?
If so, what is the proper size or scope for the overall project?
Table 18-2 lists a series of increasingly ambitious and increasingly costly highway
projects: widening existing two-lane highways; building new two-lane highways;
building new four-lane highways; building new six-lane highways. The extent to
which government should undertake highway construction depends on the costs
and benefits. The costs are largely the costs of constructing and maintaining the high-
ways; the benefit is an improved flow of people and goods throughout the nation.
The table shows that total benefit (column 4) exceeds total cost (column 2) for
plans A, B, and C, indicating that some highway construction is economically justi-
fiable. We see this directly in column 6, where total costs (column 2) are subtracted

TABLE 18-2 COST–BENEFIT ANALYSIS FOR A NATIONAL HIGHWAY

CONSTRUCTION PROJECT, BILLIONS OF DOLLARS
(1) (2) (3) (4) (5) (6)
Plan Total cost Marginal Total Marginal Net benefit
of project cost benefit benefit or (4) – (2)

No new construction $ 0 $ 0 $0
$ 4 $ 5
A: Widen existing highways 4 5 1
6 8
B: Two-lane highways 10 13 3
8 10
C: Four-lane highways 18 23 5
10 3
D: Six-lane highways 28 26 –2
 chapter eighteen • government and market failure 461

from total annual benefits (column 4). Net benefits are positive for plans A, B, and
C. Plan D is not economically justifiable because net benefits are negative.
But the question of optimal size or scope for this project remains. Comparing the
additional, or marginal, cost and the additional, or marginal, benefit relating to each
plan determines the answer. The guideline is well known to you from previous dis-
cussions: increase an activity, project, or output as long as the marginal benefit (col-
umn 5) exceeds the marginal cost (column 3). Stop the activity at, or as close as
possible to, the point at which the marginal benefit equals the marginal cost. Do not
undertake a project for which marginal cost exceeds marginal benefit.
In this case plan C (building new four-lane highways) is the best plan. Plans A
and B are too modest; the marginal benefits exceeds the marginal costs. Plan D’s
marginal cost ($10 billion) exceeds the marginal benefit ($3 billion) and therefore
cannot be justified; it overallocates resources to the project. Plan C is closest to the
theoretical optimum because its marginal benefit ($10 billion) still exceeds marginal
cost ($8 billion) but approaches the MB = MC (or MC = MB) ideal.
mc = mb This marginal cost = marginal benefit rule actually tells us which plan provides
rule For a the maximum excess of total benefits over total costs, or in other words, the plan that
government project, provides society with the maximum net benefit. You can confirm directly in column
marginal benefit
should equal mar-
6 that the maximum net benefit (of $5 billion) is associated with plan C.
ginal cost to pro- Cost–benefit analysis shatters the myth that “economy in government” and
duce maximum “reduced government spending” are synonymous. “Economy” is concerned with
benefit to society. using scarce resources efficiently. If the cost of a proposed government program
exceeds its benefits, then the proposed public program should not be undertaken,
but if the benefits exceed the cost, then it would be uneconomical or “wasteful” not
to spend on that government program. Economy in government does not mean
minimization of public spending; it means allocating resources between the private
and public sectors to achieve maximum net benefit. (Key Question 3)

● The demand (marginal–benefit) curve for a pub- ● Cost–benefit analysis is the method of evaluat-
lic good is found by vertically adding the prices ing alternative projects or sizes of projects by
all the members of society are willing to pay for comparing the marginal cost and marginal ben-
the last unit of output at various output levels. efits and applying the MC = MB rule.
● The socially optimal amount of a public good is
the amount at which the marginal cost and mar-
ginal benefit of the good are equal.

Externalities Revisited
In performing its allocation function, government not only produces public goods
externali- but also corrects for kinds of market failure called externalities or spillovers. Recall
ties Benefits or from Chapter 4 that a spillover is a cost or a benefit accruing to an individual or
costs from produc- group—a third party—that is external to a market transaction. An example of a
tion or consumption
accruing without
spillover cost or a negative externality is the cost of breathing polluted air; an exam-
compensation to ple of a spillover benefit or a positive externality is the benefit of having everyone
nonbuyers and else inoculated against some disease. When there are spillover costs, an overpro-
nonsellers of the duction of the related product occurs as does an overallocation of resources to this
product. product. Conversely, underproduction and underallocation of resources result
when spillover benefits are present. We can demonstrate both graphically.
462 Part Four • Microeconomics of Government and Public Policy

Spillover Costs
Figure 18-2(a) illustrates how spillover costs affect the allocation of resources. When
producers shift some of their costs onto the community as spillover costs, produc-
ers’ marginal costs are lower than otherwise. So their supply curves do not include
or capture all the costs legitimately associated with the production of their goods.
A polluting producer’s supply curve such as S in Figure 18-2(a), therefore, under-
<www.best.com/
states the total cost of production. The firm’s supply curve lies to the right of (or
~ddfr/Academic/
Coase_World.html> below) the full-cost supply curve St that would include the spillover cost. Through
Coase and the polluting and thus transferring cost to others in society, the firm enjoys lower pro-
Nobel Prize duction costs and has the supply curve S.
The outcome is shown in Figure 18-2(a), where equilibrium output Qe is larger
than the optimal output Qo. This means that resources are overallocated to the pro-
duction of this commodity; too many units of it are produced.

Spillover Benefits
Figure 18-2(b) shows the impact of spillover benefits on resource allocation. When
spillover benefits occur, the market demand curve D lies to the left of (or below) the
full-benefits demand curve. That is, D does not include the spillover benefits of the
product, whereas Dt does. Consider inoculations against a communicable disease.
Watson and Weinberg benefit when they get vaccinated but so do their associates
Alvarez and Anderson who are less likely to contract the disease from them. The
market demand curve reflects only the direct, private benefits to Watson and Wein-
coase
theorem The berg; it does not reflect the spillover benefits—the positive externalities—to Alvarez
idea first stated by and Anderson, which are included in Dt.
economist Ronald The outcome is that the equilibrium output Qe is less than the optimal output Qo.
Coase that spillover The market fails to produce enough vaccinations and resources are underallocated
problems may be to this product.
resolved through
private negotiations Economists have explored several approaches to the problems of spillover costs
of the affected and benefits. Let’s first look at situations where government intervention is not
parties. needed and then at some possible government solutions.

The
Individual Bargaining: Coase Theorem
Effectiveness In the Coase theorem, conceived by economist Ronald Coase at the University of
of Markets
Chicago, government is not needed to remedy spillover costs or benefits where

FIGURE 18-2 SPILLOVER COSTS AND SPILLOVER BENEFITS

Panel (a): With spillover costs P P
borne by society, the producers’ Spillover St
supply curve S is to the right of costs
(below) the full-cost curve St. St Spillover
Consequently, the equilibrium benefits
output Qe is greater than the opti- S
mal output Qo. Panel (b): When Dt
spillover benefits accrue to soci-
ety, the market demand curve D D
is to the left of (below) the full- D
Overallocation Underallocation
benefit demand curve Dt. As a
result, the equilibrium output Qe 0 Qo Qe Q 0 Qe Qo Q
is less than the optimal output Qo. (a) Spillover costs (b) Spillover benefits
 chapter eighteen • government and market failure 463

(1) property ownership is clearly defined, (2) the number of people involved is
small, and (3) bargaining costs are negligible. Under these circumstances the gov-
ernment should confine its role to encouraging bargaining between affected indi-
viduals or groups. Property rights place a price tag on an externality, creating
opportunity costs for all parties. Because the economic self-interests of the parties
are at stake, bargaining will enable them to find a mutually acceptable solution to
the externality problem.

EXAMPLE OF THE COASE THEOREM

Suppose the owner of a large parcel of forestland is considering a plan to clear-cut
(totally level) hundreds of hectares of mature fir trees. The complication is that the
forest surrounds a lake with a popular resort on its shore. The resort is on land it
owns. The unspoiled beauty of the general area attracts vacationers from all over the
nation to the resort, and the resort owner is against the clear-cutting. Should provin-
cial or municipal government intervene to allow or prevent the tree cutting?
According to the Coase theorem, the forest owner and the resort owner can
resolve this situation without government intervention. As long as one of the parties
to the dispute has property rights to what is at issue, an incentive will exist for both
<environment.about.com/ parties to negotiate a solution acceptable to each. In our example, the owner of the
newsissues/ timberland holds the property rights to the land to be logged and thus has the right
environment/library/
weekly/aa050700.htm>
to clear-cut it. The owner of the resort, therefore, has an economic incentive to nego-
Environmental tiate with the forest owner to reduce the logging impact. Excessive logging of the for-
externalities est surrounding the resort will reduce tourism and revenues to the resort owner.
What is the economic incentive to the forest owner to negotiate with the resort
owner? The answer draws directly on the idea of opportunity cost. One cost
incurred in logging the forest is the forgone payment that the forest owner could
obtain from the resort owner for agreeing not to clear-cut the fir trees. The resort
owner might be willing to make a lump-sum or annual payment to the owner of the
forest to avoid or minimize the spillover cost. Or perhaps the resort owner might be
willing to buy the forested land to prevent the logging. As viewed by the forest
owner, a payment for not clear-cutting or a purchase price above the market value
of the land is an opportunity cost of logging the land.
It is likely that both parties would regard a negotiated agreement as better than
clear-cutting the firs.

LIMITATIONS
Unfortunately, many externalities involve large numbers of affected parties, high
bargaining costs, and community property such as air and water. In such situations
private bargaining cannot be used as a remedy. As an example, the global warming
problem affects millions of people in many nations. The vast number of affected par-
ties could not individually negotiate an agreement to remedy this problem. Instead,
they must rely on their governments to represent the millions of affected parties and
find an acceptable solution.
Nevertheless, the Coase theorem reminds us that in many situations, bargaining
between private parties can be useful in remedying spillover costs and spillover
benefits.

Liability Rules and Lawsuits

Although private negotiation may not be a realistic solution to many externality
problems, clearly established property rights may help in another way. The govern-
ment has erected a framework of laws that define private property and protect it
464 Part Four • Microeconomics of Government and Public Policy

from damage done by other parties. Those laws, and the damage recovery system to
which they give rise, permit parties suffering spillover costs to sue for compensation.
Suppose the Ajax Degreaser Company regularly dumps leaky barrels containing
solvents into a nearby canyon owned by Bar Q Ranch. Bar Q eventually discovers
this dumpsite and, after tracing the drums to Ajax, immediately contacts its lawyer.
Soon after, Bar Q sues Ajax. Not only will Ajax have to pay for the cleanup; it may
also have to pay Bar Q additional damages for ruining its property.
Clearly defined property rights and government liability laws thus help remedy
some externality problems. They do so directly by forcing the perpetrator of the harm-
ful externality to pay damages to those injured. They do so indirectly by discourag-
ing firms and individuals from generating spillover costs for fear of being sued. It is
not surprising, then, that many spillovers do not involve private property but rather
property held in common by society. It is the public bodies of water, the public lands,
and the public air, where ownership is less clear, that often bear the brunt of spillovers.
A caveat is in order here: like private negotiations, private lawsuits to resolve
externalities have their own limitations. Large legal fees and major time delays in the
court system are commonplace. Also, the uncertainty associated with the court out-
come reduces the effectiveness of this approach. Will the court accept your claim that
your emphysema has resulted from the smoke emitted by the factory next door, or
will it conclude that your ailment is unrelated to the plant’s pollution? Can you prove
that a specific firm in the area is the source of the contamination of your well? What
happens to Bar Q’s suit if Ajax Degreaser goes out of business during the litigation?

Government Intervention
Government intervention may be needed to achieve economic efficiency when
externalities affect large numbers of people or when community interests are at
stake. Government can use direct controls and taxes to counter spillover costs; gov-
ernment may provide subsidies or public goods to deal with spillover benefits.

DIRECT CONTROLS
The direct way to reduce spillover costs from a certain activity is to pass legislation
limiting that activity. Such direct controls force the offending firms to incur the
actual costs of the offending activity. To date, this approach has dominated public
policy in Canada. Historically, direct controls in the form of uniform emissions stan-
dards—limits on allowable pollution—have dominated American air pollution pol-
icy. Clean air legislation forces factories, cars, and businesses to install “maximum
achievable control technology” to reduce emissions. Clean-water legislation limits
the amount of heavy metals, detergents, and other pollutants firms can discharge
into rivers and bays. Toxic-waste laws dictate special procedures and dump sites for
disposing of contaminated soil and solvents. Violating these laws means fines and,
in some cases, imprisonment.
Direct controls raise the marginal cost of production because the firms must oper-
ate and maintain pollution-control equipment. The supply curve S in Figure
18-3(b), which does not reflect the spillover costs, shifts leftward (upward) to the
full-cost supply curve, St. Product price increases, equilibrium output falls from Qe
to Qo, and the initial overallocation of resources shown in Figure 18-3(a) is corrected.

SPECIFIC TAXES
A second policy approach to spillover costs is for government to levy taxes or
charges specifically on the related good. For example, the government has placed a
 chapter eighteen • government and market failure 465

FIGURE 18-3 CORRECTING FOR SPILLOVER COSTS (NEGATIVE

EXTERNALITIES)
Panel (a): Spillover costs P P
result in an overalloca- Spillover
tion of resources. Panel costs
(b): Government can cor- St St
rect this overallocation
in two ways: (1) the use S S
of direct controls, which
would shift the supply T
curve from S to St and
D D
reduce output from Qe to Overallocation
Qo, or (2) the imposition
of a specific tax T, which 0 Qo Qe Q 0 Qo Qe Q
would also shift the sup-
ply curve from S to St,
eliminating the overallo- (a) Spillover costs (b) Correcting the overallocation
cation of resources. of resources via direct controls
or via a tax

manufacturing excise tax on CFCs, which deplete the stratospheric ozone layer pro-
tecting the earth from excessive solar ultraviolet radiation. Facing such an excise tax,
manufacturers must decide whether to pay the tax or expend additional funds to
purchase or develop substitute products. In either case, the tax raises the marginal
cost of producing CFCs, shifting the private supply curve for this product leftward
(or upward).
In Figure 18-3(b), a tax equal to T per unit increases the firm’s marginal cost, shift-
ing the supply curve from S to St. The equilibrium price rises and the equilibrium
output declines from Qe to the economically efficient level Qo. The tax thus elimi-
nates the initial overallocation of resources.

SUBSIDIES AND GOVERNMENT PROVISION

Where spillover benefits are large and diffuse, as in our earlier example of inocula-
tions, government has three options for correcting the underallocation of resources:
1. Subsidies to buyers Figure 18-4(a) again shows the supply–demand situation
for spillover benefits. Government could correct the underallocation of resources,
for example, to inoculations, by subsidizing consumers of the product. It could
give each new mother in Canada a discount coupon to be used to obtain a series
of inoculations for her child. The coupon would reduce the price to the mother
by, say, 50 percent. As shown in Figure 18-4(b), this program would shift the
demand curve for inoculations from too low D to the appropriate Dt. The num-
ber of inoculations would rise from Qe to the economically optimal Qo, eliminat-
ing the underallocation of resources shown in Figure 18-4(a).
2. Subsidies to producers A subsidy to producers is a specific tax in reverse. Taxes
impose an extra cost on producers, while subsidies reduce producers’ costs. As
shown in Figure 18-4(c), a subsidy of U per inoculation to physicians and medical
clinics would reduce their marginal costs and shift their supply curve rightward
from St to St⬘. The output of inoculations would increase from Qe to the optimal
level Qo, correcting the underallocation of resources shown in Figure 18-4(a).
466 Part Four • Microeconomics of Government and Public Policy

FIGURE 18-4 CORRECTING FOR SPILLOVER BENEFITS (POSITIVE

EXTERNALITIES)
P P P
St St
St
Subsidy
Spillover
benefits S′t
Dt
Dt Subsidy
U D
D D
Underallocation
0 Qe Qo Q 0 Qe Qo Q 0 Qe Qo Q

(a) Spillover benefits (b) Correcting the (c) Correcting the

underallocation of underallocation of
resources via a subsidy resources via a subsidy
to consumers to producers

Panel (a): Spillover benefits result in an underallocation of resources. Panel (b): This underallocation can be corrected by a
subsidy to consumers, which shifts market demand from D to Dt and increases output from Qe to Qo. Panel (c): Alternatively,
the underallocation can be eliminated by providing producers with a subsidy of U, which shifts their supply curve from St to
S⬘t , increasing output from Qe to Qo.

tragedy 3. Government provision Finally, where spillover benefits are extremely large, the
of the government may decide to provide the product as a public good. The Canadian
commons Air, government largely eradicated the crippling disease polio by administering free
water, and public
land rights are vaccines to all children. India ended smallpox by paying people in rural areas to
held in common by come to public clinics to have their children vaccinated. (Key Question 4)
society and freely
available, so no
incentive exists to A Market-Based Approach to Spillover Costs
maintain or use One novel approach to spillover costs involves only limited government action. The
them carefully; the idea is to create a market for externality rights. But before describing that approach,
result is overuse,
degradation, and
we first need to understand the idea called the tragedy of the commons.
pollution.
THE TRAGEDY OF THE COMMONS
The air, rivers, lakes, oceans, and public lands, such as parks and streets, are all
objects for pollution because the rights to use those resources are held in common
by society. No private individual or institution has a monetary incentive to maintain
the purity or quality of such resources.
We maintain the property we own, we paint and repair our homes periodically, for
example, in part because we will recoup the value of these improvements at the time
<www.ecoplan.org/
com_index.htm> of sale. But as long as rights to air, water, and certain land resources are commonly
The commons held and are freely available, no incentive exists to maintain them or use them care-
sustainability agenda fully. As a result, these natural resources are overused and degraded or polluted.
For example, a common pasture in which anyone can graze cattle will quickly be
overgrazed, because each rancher has an incentive to graze as many cattle as possi-
ble. Similarly, commonly owned resources such as rivers, lakes, oceans, and the air
get used beyond their capacity to absorb pollution. Manufacturers will choose the
 chapter eighteen • government and market failure 467

least-cost combination of inputs and bear only unavoidable costs. If they can dump
waste chemicals into rivers and lakes rather than pay for proper disposal, some
businesses will be inclined to do so. Firms will discharge smoke into the air if they
can, rather than purchase expensive abatement facilities. Even federal, provincial,
and municipal governments sometimes discharge inadequately treated waste into
rivers, lakes, or oceans to avoid the expense of constructing expensive treatment
facilities. Many individuals avoid the costs of proper refuse pickup and disposal by
burning their garbage or dumping it in the woods.
The problem is mainly one of incentives. There is no incentive to incur internal
costs associated with reducing or eliminating pollution when those costs can be
market for transferred externally to society. The fallacy of composition also comes into play.
externality Each person and firm reasons their individual contribution to pollution is so small
rights A market that it is of little or no overall consequence. But their actions, multiplied by hun-
in which firms can
buy rights to dis- dreds, thousands, or millions, overwhelm the absorptive capacity of the common
charge pollutants. resources. Society ends up with a degradation or pollution problem.

A MARKET FOR EXTERNALITY RIGHTS

The
This outcome gives rise to a novel policy approach to spillover costs—one that is
Effectiveness market oriented. The idea is that the government can create a market for external-
of Markets
ity rights. We confine our discussion to pollution, although this same approach
might be used with other externalities.

OPERATION OF THE MARKET

In this market approach, an appropriate pollution-control agency would determine
the amount of pollutants that firms can discharge into the water or air of a specific
region annually while maintaining the water or air quality at some acceptable level.
Suppose the agency ascertains that 500 tonnes of pollutants can be discharged into
Metropolitan Lake and “recycled” by nature each year. Then 500 pollution rights,
each entitling the owner to dump one tonne of pollutants into the lake in one year,
are made available for sale to producers each year. The supply of these pollution
rights is fixed and, therefore, perfectly inelastic, as shown in Figure 18-5.

FIGURE 18-5 A MARKET FOR POLLUTION RIGHTS

The supply of pollution rights, S, P
is set by the government, which
determines that a specific body D 2012 S = Supply of
Price per pollution right

of water can safely recycle 500 pollution

tonnes of waste. In 2002, the D 2002 rights
demand for pollution rights is D2002 $200
and the one-tonne price is $100.
The quantity of pollution is 500
tonnes, not the 750 tonnes it would
have been without the pollution
rights. Over time, the demand for $100
pollution rights increases to D2012
and the one-tonne price rises to
$200. But the amount of pollution
stays at 500 tonnes, rather than
rising to 1000 tonnes. 0 500 750 1000 Q
Quantity of One-tonne pollution rights
468 Part Four • Microeconomics of Government and Public Policy

The demand for pollution rights, represented by D2002 in the figure, takes the same
downsloping form as the demand for any other input. At higher prices there is less
pollution, as polluters either stop polluting or pollute less by acquiring pollution-
abatement equipment. An equilibrium market price for pollution rights, here $100,
will be determined at which the environment-preserving quantity of pollution
rights is rationed to polluters. Figure 18-5 shows that if the use of the lake as a
dumpsite for pollutants were free, 750 tonnes of pollutants would be discharged
into the lake; it would be overconsumed, or polluted, in the amount of 250 tonnes.
Over time, as human and business populations expand, demand will increase, as
from D2002 to D2012. Without a market for pollution rights, pollution in 2012 would be
1000 tonnes, 500 tonnes beyond what can be assimilated by nature. With the market
for pollution rights, the price would rise from $100 to $200, and the amount of pol-
lutants would remain at 500 tonnes—the amount that the lake can recycle.

ADVANTAGES
This scheme has several advantages over direct controls, the most important of
which is that it reduces society’s costs by allowing pollution rights to be bought and
sold. Suppose it costs Acme Pulp Mill $20 a year to reduce a specific noxious dis-
charge by one tonne while it costs Zemo Chemicals $8000 a year to accomplish the
same one-tonne reduction. Also assume that Zemo wants to expand production, but
doing so will increase its pollution discharge by one tonne.
Without a market for pollution rights, Zemo would have to use $8000 of society’s
scarce resources to keep the one-tonne pollution discharge from occurring. But with
a market for pollution rights, Zemo has a better option: it buys one tonne of pollu-
tion rights for the $100 price shown in Figure 18-5. Acme is willing to sell Zemo one
tonne of pollution rights for $100 because that amount is more than Acme’s $20 cost
of reducing its pollution by one tonne. Zemo increases its discharge by one tonne;
Acme reduces its discharge by one tonne. Zemo benefits (by $8000 – $100), Acme
benefits (by $100 – $20), and society benefits (by $8000 – $20). Rather than using
$8000 of its scarce resources to hold the discharge at the specified level, society uses
only $20 of those resources.
Market-based plans have other advantages. Potential polluters have a monetary
incentive not to pollute because they must pay for the rights to discharge effluent.
Conservation groups can fight pollution by buying up and withholding pollution
rights, thereby reducing pollution below governmentally determined standards. As
the demand for pollution rights increases over time, the growing revenue from the
sale of a fixed quantity of pollution rights could be devoted to environmental
improvement. At the same time, the rising price of pollution rights should stimu-
late the search for improved pollution-control techniques.
Table 18-3 reviews the major methods for correcting externalities.

Society’s Optimal Amount of Externality Reduction

Choosing
Negative externalities such as pollution reduce the utility of those affected, rather
a Little More than increase it. These spillovers are not economic goods but economic “bads.” If
or Less
something is bad, shouldn’t society eliminate it? Why should society allow firms or
municipalities to discharge any impure waste into public waterways or to emit any
pollution into the air?
Reducing a negative externality has a price. Society must decide how much of a
reduction it wants to buy. Eliminating pollution might not be desirable, even if it
were technologically feasible. Because of the law of diminishing returns, cleaning
 chapter eighteen • government and market failure 469

TABLE 18-3 METHODS FOR DEALING WITH EXTERNALITIES

Problem Resource allocation outcome Ways to correct externalities

Spillover costs Overallocation of resources 1. Individual bargaining

(negative externalities) 2. Liability rules and lawsuits
3. Tax on producers
4. Direct controls
5. Market for externality rights
Spillover benefits Underallocation of resources 1. Individual bargaining
(positive externalities) 2. Subsidy to consumers
3. Subsidy to producers
4. Government provision

up the last 10 percent of pollutants from an industrial smokestack normally is far

more costly than cleaning up the prior 10 percent.
The marginal cost (MC) to the firm and hence to society—the opportunity cost of
the extra resources used—rises as pollution is reduced further. At some point MC
may rise so high that it exceeds society’s marginal benefit (MB) of further pollution
abatement (reduction). Additional actions to reduce pollution will therefore lower
society’s well-being; total cost will rise more than total benefit.

MC, MB, AND EQUILIBRIUM QUANTITY

Figure 18-6 shows both the rising marginal-cost curve, MC, for pollution reduction
and the downsloping marginal-benefit curve, MB, for this outcome. MB slopes

FIGURE 18-6 SOCIETY’S OPTIMAL AMOUNT OF POLLUTION

ABATEMENT
The optimal amount
Society’s marginal benefit and marginal

of externality reduc-
MC
tion—in this case,
pollution abate-
cost of pollution abatement

ment—occurs at Q1,
where society’s mar-
ginal cost MC and
marginal benefit MB Socially
of reducing the optimal amount
spillover are equal. of pollution
abatement

MB

0 Q1
Amount of pollution abatement
470 Part Four • Microeconomics of Government and Public Policy

downward because of the law of diminishing marginal utility: the more pollution
reduction society accomplishes, the lower the utility (and benefit) of the next unit
of pollution reduction.
optimal The optimal reduction of an externality occurs when society’s marginal cost and
reduction marginal benefit of reducing that externality are equal (MC = MB). In Figure 18-6 this
of an optimal amount of pollution abatement is Q1 units. When MB exceeds MC, additional
externality abatement moves society toward economic efficiency; the added benefit of cleaner air
The point at which
society’s marginal or water exceeds the benefit of any alternative use of the required resources. When MC
cost and marginal exceeds MB, additional abatement reduces economic efficiency; there would be greater
benefit of reducing benefits from using resources in some other way than to further reduce pollution.
that externality In reality, it is difficult to measure the marginal costs and benefits of pollution
are equal.
control. Nevertheless, Figure 18-6 demonstrates that some pollution may be eco-
nomically efficient not because pollution is desirable but because beyond some level
of control, further abatement may reduce our net well-being.

SHIFTS IN LOCATIONS OF CURVES

The locations of the marginal-cost and marginal-benefit curves in Figure 18-6 are not
forever fixed. They can, and probably do, shift over time. For example, suppose that
the technology of pollution-control equipment were to improve noticeably. We
would expect the cost of pollution abatement to fall, society’s MC curve to shift
rightward, and the optimal level of abatement to rise. Or suppose that society were
to decide that it wanted cleaner air and water because of new information about the
adverse health effects of pollution. The MB curve in Figure 18-6 would shift right-
ward, and the optimal level of pollution control would increase beyond Q1. Test
your understanding of these statements by drawing the new MC and MB curves in
Figure 18-6. (Key Question 7)

● Policies for coping with the overallocation of
resources caused by spillover costs are (1) pri-
vate bargaining, (2) liability rules and lawsuits,
(3) direct controls, (4) specific taxes, and (5) mar-
kets for externality rights.
● Policies for correcting the underallocation of
resources associated with spillover benefits are
(1) private bargaining, (2) subsidies to produc-
ers, (3) subsidies to consumers, and (4) govern-
ment provision.
● The optimal amount of negative-externality
reduction occurs where society’s marginal cost
and marginal benefit of reducing the externality
are equal.

Solid-Waste Disposal and Recycling

One externality problem that has received widespread attention in Canada is solid
law of con- waste disposal. The root cause of the problem can be envisioned through the law of
servation conservation of matter and energy. This law holds that matter can be transformed
of matter to other matter or into energy but can never vanish. All inputs (fuels, raw materi-
and energy als, water, and so forth) used in the economy’s production processes will ultimately
Matter can be result in an equivalent amount of waste. For example, unless it is continuously recy-
transformed into
other matter or cled, the cotton found in a T-shirt ultimately will be abandoned in a closet, buried
into energy but can in a dump, or burned in an incinerator. Even if it is burned, it will not vanish;
never vanish. instead, it will be transformed into heat, smoke, and ash.
 chapter eighteen • government and market failure 471

The law of conservation of matter and energy is most apparent in solid-waste dis-
posal. The millions of tonnes of garbage that accumulate annually in Canadian land-
fills (trash dumps) are a growing externality problem. Landfills in southern Ontario
in particular are either completely full or rapidly filling up. Garbage from there and
elsewhere is now being transported hundreds of miles to dumps in other municipal
jurisdictions.
On the receiving end, people in rural areas near newly expanding dumps are
understandably upset about the increased truck traffic on their highways and the
growing mounds of smelly garbage in municipal dumps. Moreover, some landfills
are producing serious water-supply pollution.
The high opportunity cost of urban and suburban land and the negative exter-
nalities created by dumps make landfills increasingly expensive. An alternative pol-
icy is to incinerate garbage in plants that produce electricity. But people object to
having garbage incinerators, with their accompanying truck traffic and air pollution,
close to their homes. Is there a better solution to the growing problem of solid waste?
Although garbage dumps and incinerators remain the primary garbage disposal
methods, recycling has received increased attention.

MARKET FOR RECYCLABLE INPUTS

Figure 18-7(a), which shows the demand and supply curves for some recyclable
product, such as glass, suggests the incentives for recycling.
The demand for recyclable glass derives from manufacturers that use recycled
glass as a resource in producing new glass. This demand curve slopes downward,
telling us that manufacturers will increase their purchases of recyclable glass as
its price falls.

FIGURE 18-7 THE ECONOMICS OF RECYCLING

P P P
Increase in
S1 demand S Increase in S1
1
supply
Price

Price

Price

P2 S2
P1 P1 P1
D2
P3
D1 D1 D1
0 Q1 Q 0 Q1 Q2 Q 0 Q1 Q3 Q

Amount of recycling Amount of recycling Amount of recycling

(a) Equilibrium price (b) Incentives to buy (c) Incentives to sell
and quantity recyclable inputs recyclable inputs
Panel (a): The equilibrium price and amount of materials recycled are determined by supply S1 and demand D1. Panel (b):
Policies that increase the incentives for producers to buy recyclable inputs shift the demand curve rightward, say, to D2, and
raise both the equilibrium price and the amount of recycling. Panel (c): Policies that encourage households to recycle shift
the supply curve rightward, say, to S2, and expand the equilibrium amount of recycling. These policies, however, also reduce
the equilibrium price of the recycled inputs.
472 Part Four • Microeconomics of Government and Public Policy

The location of the demand curve in Figure 18-7(a) depends partly on the
demand for the products for which the recycled glass is used. The greater the
demand for those products, the greater the demand for the recyclable input. The
location of the curve also depends on the technology and thus the cost of using orig-
inal raw materials rather than recycled glass in the production process. The more
costly it is to use original materials relative to recycled glass, the farther to the right
will be the demand curve for recyclable glass.
The supply curve for recyclable glass slopes upward, because higher prices
increase the incentive for households to recycle. The location of the supply curve
depends on such factors as the attitudes of households toward recycling and the
cost to them of alternative disposal.
The equilibrium price P1 and quantity Q1 in Figure 18-7(a) are determined at the
intersection of the supply and demand curves. At price P1 the market clears; there
is neither a shortage nor a surplus of recyclable glass.

POLICY
Suppose the government wants to encourage recycling as an alternative to land
dumps or incineration. It could do that in one of two ways.
Demand Incentives The government could increase recycling by increasing the
demand for recycled inputs. If the demand curve in Figure 18-7(b) shifts from D1
rightward to D2, the equilibrium price and quantity of recycled glass will increase to
P2 and Q2; more recycling will occur. A policy that might increase demand would be
to place taxes on the inputs that are substitutable for recycled glass in the production
process. Such taxes would encourage firms to use more of the untaxed recycled glass
and less of the taxed inputs. Or the government could shift its purchases toward
goods produced with recycled inputs and require that its contractors do the same
Also, environmental awareness by the public can contribute to rightward shifts
of the demand curve for recycled resources. Many large firms that produce waste-
intensive goods have concluded that it is in their interest to support recycling, for
fear of a consumer backlash against their products. Procter & Gamble (disposable
diapers) and McDonald’s (packaging of fast food) have undertaken multimillion-
dollar campaigns to use recycled plastic and paper.
Supply Incentives As shown in Figure 18-7(c), government can also increase recy-
cling by shifting the supply curve rightward, as from S1 to S2. The equilibrium price
would fall from P1 to P3, but the equilibrium quantity—in this case recyclable
glass—would rise from Q1 to Q3. That is, more recycling would occur. Many munic-
ipal governments have implemented specific policies to do so. For example, they
encourage recycling by providing curbside pickup of recyclable goods such as
glass, aluminum cans, and newspapers at a lower monthly fee than for the pickup
of other garbage, or free of charge.
In a few cases, supply incentives for recyclables have been so effective that the
price of a recycled item has fallen to zero. You can envision this outcome by shifting
the supply curve in Figure 18-7(c) farther rightward. Some cities now are paying
users of recyclable inputs such as mixed paper to truck them away from the recycling
centre, which means that these items have a negative price. If the cost of paying firms
to take away recyclable products is lower than the cost of alternative methods, even
such paid-for recycling will promote economic efficiency. However, if it is more
costly to recycle trash than to bury or incinerate it, even when externalities are con-
sidered, such recycling will reduce efficiency rather than increase it. Again, we are
reminded that there can be either too little or too much of a good thing.
 chapter eighteen • government and market failure 473

The government’s task is to find the optimal amount of recycling compared with
the alternative disposal of garbage. It can do this by estimating and comparing the
marginal benefit and marginal cost of recycling. Consumers as a group can reduce
the accumulation of garbage by buying products that have minimal packaging.

Global Warming
Canada and the United States have made significant progress in cleaning their air.
According to the United States Environment Protection Agency, between 1990 and
2000 clean-air laws and antipollution efforts by businesses and municipal govern-
ments reduced concentrations of carbon monoxide by 36 percent, lead by 60 percent,
nitrogen dioxide by 10 percent, smog by 4 percent, particulate matter by 18 percent,
and sulphur dioxide by 36 percent.
But significant air pollution problems remain. Millions live in areas, such as
southern Ontario, that have unhealthy levels of at least one of the six major air pol-
lutants listed above. Moreover, Canada and the other nations of the world face the
risks of global warming. The balance of scientific evidence suggests that carbon dioxide
and other gas emissions from factories, power plants, and automobiles are accu-
mulating in the atmosphere and creating a greenhouse effect. As a result, many sci-
entists predict that average temperatures will rise by 1 to 3 degrees Celsius by 2100.
In turn, almost all regions of the world will experience noticeable climatic changes.
Ocean levels will gradually rise by several inches, and rainfall patterns will change.
Snow accumulations will decline in some regions and rise in others. Violent storms
such as tornadoes, typhoons, and hurricanes could increase in frequency and sever-
ity. But the economic effects of global warming will not be uniform; cool and tem-
perate regions and nations may economically benefit, and hot and dry regions and
nations may be harmed. Global Perspective 18.1 lists carbon dioxide emissions on
a per capita basis for selected nations.
The world’s nations have responded to the global warming problem by promising
to limit the growth of carbon dioxide and other greenhouse emissions. Specifically,

18.1

Carbon Dioxide Emissions,

Carbon dioxide (Per Capita, 1999)
emissions, tonnes per 0 5 10 15 20 25
capita, selected nations
United States
Carbon dioxide emissions, the Australia
major type of greenhouse gas Canada
emissions, vary per capita by Czech Republic
nation primarily because of dif- Germany
ferent degrees of industrialization Britain
and energy production from fossil Japan
fuels (coal, oil, and natural gas). The Italy
burning of such fuels is the major Spain
France
contributor to global warming.
Source: OECD Environmental Data, <www.oecd.org>, Compendium, 1999.
 474 Part Four • Microeconomics of Government and Public Policy

the industrially advanced nations agreed in the 1997 Kyoto Protocol to cut their
greenhouse gas emissions 6 to 8 percent below 1990 levels by 2012. Canada com-
mitted to a 6 percent reduction below 1990 levels by 2012. Many contentious issues
remain to be resolved through further meetings and negotiations. For example, to
what extent should developing nations such as China and India, currently exempt
from the limits, participate in reducing emissions? Should all industrial countries be
<www.crt.umontreal.ca/
forced to make, say, at least half their agreed-on reduction at home, rather than buy-
~amit/papers/cjm.pdf> ing tradable emissions credits from other nations and making no reductions at
The Kyoto Protocol home? Such credits were established as part of the Kyoto Protocol.
Economists stress that global warming policies that reduce greenhouse gas emis-
sions and thus slow or eliminate global warming create costs as well as benefits. It
is imperative to consider the marginal costs and marginal benefits carefully when
making policy decisions. Greenhouse gas limits should not be so stringent that they
end up costing society more than the value of the benefits they produce. But limits
should not be so lenient that society forgoes substantial potential benefits that it
would have otherwise achieved.
Economists also stress that the market mechanism, through its system of prices
and profits and losses, will make appropriate adjustments based on new climatic
asymmetric realities. Air conditioner sales will rise; snow shovel sales will fall. Some agricultural
information lands will be deserted; others further north will be cultivated. The maple syrup
A situation in which industry in Canada may benefit if production in New England falls as a result of
one party to a mar- global warming. Nevertheless, the transition costs—the costs associated with mak-
ket transaction has ing economic adjustments—of global warming will undoubtedly be very high if no
much more informa-
tion about a product
actions are taken to reduce greenhouse gases. The reduction or elimination of these
or service than the transition costs is part of the benefit of slowing or eliminating the greenhouse
other does. effect. Such benefits must be fully considered in the cost–benefit analysis.

● The ultimate reason for pollution is the law of
conservation of matter and energy, which holds
that matter can be transformed into other mat-
ter or into energy but cannot vanish.
● Society’s pollution problem has largely resulted
from increasing population, levels rising per
capita consumption, certain changes in technol-
ogy, and the so-called tragedy of the commons.
● The government can encourage recycling
through demand and supply incentives; its task
is to determine the optimal amount of recycling.
● Under terms of the 1997 Kyoto Protocol, the
industrial nations agreed to cut emissions of
greenhouse gases by 6 to 8 percent below the
1990 levels by 2012.

Information Failures
Thus far, we have added new detail and insights concerning two types of market
The Role of
Governments failure: public goods and externalities. There is another, subtler, market failure that
results when either buyers or sellers have incomplete or inaccurate information, and
their cost of obtaining better information is prohibitive. Technically stated, this
market failure occurs because of asymmetric information—unequal knowledge
possessed by the parties to a market transaction. Buyers and sellers do not have
identical information about price, quality, or some other aspect of the good or
service.
 chapter eighteen • government and market failure 475

Sufficient market information normally is available to ensure that goods and

services are produced and purchased efficiently. But in some cases, inadequate
information makes it difficult to distinguish trustworthy from untrustworthy sell-
ers or trustworthy from untrustworthy buyers. In these markets, society’s scarce
resources may not be used efficiently, implying that the government should inter-
vene by increasing the information available to the market participants. Under rare
circumstances the government may itself supply a good for which information
problems have prohibited efficient production.

Inadequate Information Involving Sellers

Inadequate information about sellers and their products can cause market failure in
the form of underallocation of resources. Examining the markets for gasoline and
for the services of surgeons will show us how this comes about.

EXAMPLE: THE GASOLINE MARKET

Assume an absurd situation: Suppose no system of weights and measures was
established by law, no government inspection of gasoline pumps took place, and no
law against false advertising existed. Each gas station can use whatever measure it
chooses; it can define a litre of gas as it pleases. A station can advertise that its gas
is 87 octane when in fact it is only 75. It can rig its pumps to indicate that it is pro-
viding more gas than the amount being delivered.
Obviously, the consumers’ cost of obtaining reliable information under such
chaotic conditions is exceptionally high, if not prohibitive. Customers or their rep-
resentatives would have to buy samples of gas from various gas stations, have them
tested for octane level, and test the accuracy of calibrations at the pump. These activ-
ities would have to be repeated regularly, because a station owner could alter the
product quality and the accuracy of the pump at will.
Because of the high costs of obtaining information about the seller, many cus-
tomers would opt out of this chaotic market. One tankful of a 50 percent solution of
gasoline and water would be enough to discourage most motorists from further
driving. More realistically, the conditions in this market would encourage con-
sumers to vote for political candidates who promised to provide a governmental
solution. The oil companies and honest gasoline stations would not object to gov-
ernment intervention. They would realize that accurate information, by enabling
this market to work, would expand their total sales and profit.
The government has in fact intervened in the market for gasoline and other
markets with similar potential information difficulties. It established a system of
weights and measures, employs inspectors to check the accuracy of gasoline
pumps, and passed laws against fraudulent claims and misleading advertising.
There can be no doubt that these government activities have produced net benefits
for society.

EXAMPLE: LICENSING OF SURGEONS

Suppose now that anyone could hang out a shingle and claim to be a surgeon, much
as anyone can become a house painter. The market would eventually sort out the
true surgeons from those who were learning by doing or were fly-by-night opera-
tors who moved into and out of an area. As people died from unsuccessful surgery,
lawsuits for malpractice eventually would eliminate the medical impostors. People
needing surgery for themselves or their loved ones could obtain information from
newspaper reports or from people who had undergone similar operations.
476 Part Four • Microeconomics of Government and Public Policy

But this process of obtaining information for those needing surgery would take
considerable time and would impose unacceptably high human and economic costs.
There is a fundamental difference between getting an amateurish paint job on one’s
house and being on the receiving end of heart surgery by a bogus physician. The
marginal cost of obtaining information about sellers in the surgery market would be
excessively high. The risk of proceeding without good information would result in
much less surgery than desirable—an underallocation of resources to surgery.
The government has remedied this market failure through a system of qualifying
tests and licensing. The licensing provides consumers with inexpensive information
about a service they infrequently buy. The government has taken a similar role in
several other areas of the economy. For example, it approves new medicines, regu-
lates the securities industry, and requires warnings on containers of potentially haz-
ardous substances. It also requires warning labels on cigarette packages and
disseminates information about communicable diseases. And it issues warnings
about unsafe toys and inspects restaurants for health-related violations.

Inadequate Information Involving Buyers

Just as inadequate information involving sellers can keep markets from achieving
economic efficiency, so can inadequate information relating to buyers. The buyers
may be consumers who buy products or firms that buy resources.

MORAL HAZARD PROBLEM

Private markets may underallocate resources to a particular good or service for
moral which there is a severe moral hazard problem. The moral hazard problem is the ten-
hazard dency of one party to a contract to alter her or his behaviour after the contract is
problem The signed in ways that could be costly to the other party.
possibility that indi-
viduals or institu-
Suppose a firm offers an insurance policy that pays a set amount of money per
tions will change month to people who suffer divorces. The attractiveness of such insurance is that it
their behaviour as would pool the economic risk of divorce among thousands of people and, in par-
the result of a con- ticular, would protect spouses and children from the economic hardship that
tract or agreement. divorce often brings. Unfortunately, the moral hazard problem reduces the likeli-
hood that insurance companies can profitably provide this type of insurance.
After taking out such insurance, some people would alter their behaviour in
ways that impose heavy costs on the insurer. For example, married couples would
have less incentive to get along and to iron out marital difficulties. At the extreme,
some people might be motivated to obtain a divorce, collect the insurance, and then
continue to live together. Such insurance could even promote more divorces, the
very outcome it is intended to protect against. The moral hazard problem would
force the insurer to charge such high premiums for this insurance that few policies
would be bought. If the insurer could identify in advance those people most prone
to alter their behaviour, the firm could exclude them from buying it. But the firm’s
marginal cost of getting such information is too high compared with the marginal
benefit. Thus, this market would fail.
Although divorce insurance is not available in the marketplace, society recog-
nizes the benefits of insuring against the hardships of divorce. It has corrected for
this underallocation of hardship insurance through child-support laws that dictate
payments to the spouse who retains the children, when the economic circumstances
warrant such payments. Alimony laws also play a role.
The moral hazard problem is also illustrated in the following statements:
 chapter eighteen • government and market failure 477

● Drivers may be less cautious because they have car insurance.

● Medical malpractice insurance may increase the amount of malpractice.
● Guaranteed contracts for professional athletes may reduce the quality of their
performance.
● Employment compensation insurance may lead some workers to shirk.
● Government insurance on bank deposits may encourage banks to make risky
loans.

ADVERSE SELECTION PROBLEM

Another information problem resulting from inadequate information involving
adverse buyers is the adverse selection problem. This problem arises when information
selection known by the first party to a contract is not known by the second and, as a result,
problem A the second party incurs major costs. Unlike the moral hazard problem, which arises
problem arising
when information
after a person signs a contract, the adverse selection problem arises at the time a per-
known to one party son signs a contract.
to a contract is In insurance, the adverse selection problem is that people who are most likely to
not known to the need insurance payouts are those who buy insurance. For example, those in poor-
other party, causing est health will seek to buy the most generous health insurance policies. Or, at the
the latter to incur
major costs.
extreme, a person planning to hire an arsonist to torch his failing business has an
incentive to buy fire insurance.
Our hypothetical divorce insurance sheds further light on the adverse selec-
tion problem. If the insurance firm sets the premiums based on the average divorce
rate, many married couples who are about to obtain a divorce will buy insurance.
An insurance premium based on average probabilities will make a great buy for
those about to get divorced. Meanwhile, those in highly stable marriages will
not buy it.
The adverse selection problem thus tends to eliminate the pooling of low and
high risks, which is the basis of profitable insurance. Insurance rates then must be
so high that few people would want to (or be able to) buy such insurance.
Where private firms underprovide insurance because of information problems,
the government often establishes some type of social insurance. It can require every-
one in a particular group to take the insurance and thereby can overcome the
adverse selection problem. For example, although the social insurance system in
Canada is partly insurance and partly an income transfer program, in its broadest
sense it is insurance against poverty during old age. The social insurance program
requires nearly universal participation: People who are most likely to need the min-
imum benefits that social insurance provides are automatically participants in the
program. So, too, are those not likely to need the benefits. No adverse selection
problem exists.

WORKPLACE SAFETY
The labour market also provides an example of how inadequate information about
buyers (employers) can produce market failures.
For several reasons employers have an economic incentive to provide safe work-
places. A safe workplace reduces the amount of disruption of the production
process created by job accidents and lowers the costs of recruiting, screening, train-
ing, and retaining new workers. It also reduces a firm’s worker compensation insur-
ance premiums (legally required insurance against job injuries).
478 Part Four • Microeconomics of Government and Public Policy

But a safe workplace is expensive: safe equipment, protective gear, and a slower
work pace all entail costs. The firm will decide how much safety to provide by
comparing the marginal cost and marginal benefit of providing a safer workplace.
Will this amount of job safety achieve economic efficiency, as well as maximize the
firm’s profit?
The answer is yes if the labour and product markets are competitive and if work-
ers are fully aware of the job risks at various places of employment. With full infor-
mation, workers will avoid employers having unsafe workplaces. The supply of
labour to these establishments will be greatly restricted, forcing them to boost their
wages to attract a workforce. The higher wages will then give these employers an
incentive to provide increased workplace safety; safer workplaces will reduce wage
expenses. Only firms that find it very costly to provide safer workplaces will choose
to pay high compensating wage differentials rather than reduce workplace hazards.
A serious problem arises when workers do not know that particular occupations
or workplaces are unsafe. Because information about the buyer—that is, about the
employer and the workplace—is inadequate, the firm may not need to pay a wage
premium to attract its workforce. Its incentive to remove safety hazards, therefore,
will be diminished, and its profit-maximizing level of workplace safety will be less
than economically desirable. In brief, the labour market will fail because of asym-
metric information—in this case, sellers (workers) having less information than
buyers (employers).
The government has several options for remedying this information problem:
● It can directly provide information to workers about the injury experience of
various employers, much as it publishes the on-time performance of airlines.
● It can require that firms provide information to workers about known work-
place hazards.
● It can establish standards of workplace safety and enforce them through
inspections and penalties.
Although the federal government has mainly employed the standards and enforce-
ment approach to improve workplace safety, some critics contend that an informa-
tion strategy might be less costly and more effective. (Key Question 13)

Qualification
People have found many ingenious ways to overcome information difficulties with-
out government intervention. For example, many firms offer product warranties to
overcome the lack of information about themselves and their products. Franchising
also helps overcome this problem. When you visit a McDonald’s or a Holiday Inn,
you know precisely what you are going to get, as opposed to stopping at Bob’s
Hamburger Shop or the Bates Motel.
Also, some private firms and organizations specialize in providing information
to buyers and sellers. Consumer Reports provides product information; labour unions
collect and disseminate information about job safety; and credit bureaus provide
information to insurance companies. Brokers, bonding agencies, and intermediaries
also provide information to clients.
Economists agree, however, that the private sector cannot remedy all information
problems. In some situations, government intervention is desirable to promote an
efficient allocation of society’s scarce resources.
 chapter eighteen • government and market failure 479

● Asymmetric information is a source of poten-
tial market failure, causing society’s scarce re-
sources to be allocated inefficiently.
● Inadequate information about sellers and their
products may lead to an underallocation of
resources to those products.
● The moral hazard problem is the tendency of
one party to a contract to alter its behaviour
in ways that are costly to the other party; for
example, a person who buys insurance may
willingly incur added risk.
● The adverse selection problem arises when one
party to a contract has less information than
the other party and incurs a cost because of
that asymmetrical information. For example, an
insurance company offering no-medical-exam-
required life insurance policies may attract cus-
tomers who have life-threatening diseases.

LOJACK: A CASE OF POSITIVE

Private expenditures to reduce
crime are estimated to be $30
billion annually and are growing
at a faster rate than spending on
public crime prevention. Unfor-
tunately, some forms of private
crime prevention simply redis-
tribute crime rather than reduce
it. For example, car alarm sys-
tems that have red blinking
warning lights may simply divert
professional auto thieves to ve-
hicles that do not have such
lights and alarms. The owner of
a car with such an alarm system
benefits through the reduced
likelihood of theft but imposes a
cost on other car owners who do
not have such alarms. Their cars
are more likely to be targeted by
thieves because other cars have
visible security systems.
Some private crime preven-
tion measures, however, actually
reduce crime, rather than simply
EXTERNALITIES
Economists Ian Ayres and Steven Levitt find that
an auto antitheft device called Lojack produces
large spillover benefits.
redistribute it. One such meas-
ure is installation of a Lojack (or
some similar) car retrieval sys-
tem. Lojack is a tiny radio trans-
mitter that is hidden within one
of many possible places within
the car. When an owner reports
a stolen car, the police can re-
motely activate the transmitter.
Police can then determine its
precise location and track its
subsequent movements.
The owner of the car benefits
because the 95 percent retrieval
rate on cars with the Lojack sys-
tem is higher than the 60 percent
retrieval rate for cars without
the system. But, according to a
study by Ayres and Levitt, the
benefit to the car owner is only
10 percent of the total benefit.
Ninety percent of the total bene-
fit is external; it is a spillover
benefit to other car owners in
the community.
There are two sources of this
positive externality. First, the
presence of the Lojack device
sometimes enables police to in-
tercept the car while the thief
is still driving it. For example, in
California the arrest rate for cars
with Lojack was three times
greater than for cars without it.
The arrest puts the car thief out
of commission for a time and
thus reduces subsequent car
thefts in the community. Second,
and far more important, the de-
vice enables police to trace cars
to chop-shops where crooks dis-
assemble cars for resale of the
parts. When police raid the chop-
shop, they put the entire theft
ring out of business. In Los An-
geles alone, Lojack has elimi-
nated 45 chop-shops in just a few
years. The purging of the chop-
shop and theft ring reduces auto
theft in the community. So, auto
480 Part Four • Microeconomics of Government and Public Policy

owners who do not have Lojack
devices in their cars benefit from
car owners who do. Ayres and
Levitt estimate the marginal so-
cial benefit of Lojack—the mar-
ginal benefit to the Lojack car
owner plus the spillover benefit
to other car owners—is 15 times
greater than the marginal cost of
the device.
We saw in Figure 18-4(a) that
the existence of positive exter-
nalities causes an insufficient
quantity of a product and thus
an underallocation of scarce re-
sources to its production. The
two general ways to correct the
outcome are to subsidize the
consumer, as shown in Figure
18-4(b) or to subsidize the pro-
ducer, as shown in Figure 18-
4(c). Currently, there is only one
form of government intervention
in place: provincial-mandated in-
surance discounts for people
who install auto retrieval sys-
tems such as Lojack. Those dis-
counts on insurance premiums,
in effect, subsidize the consumer
by lowering the price of the sys-
tem to consumers: the lower
price raises the number of sys-
tems installed. But based on
their research, Ayres and Levitt
contend that the current levels of
insurance discounts are far too
small to correct the underalloca-
tion that results from the positive
externalities created by Lojack.
Source: Based on Ian Ayres and
Steven D. Levitt, “Measuring Posi-
tive Externalities from Unobservable
Victim Precaution: An Empirical
Analysis of Lojack,” Quarterly Jour-
nal of Economics, February 1998,
pp. 43–77. The authors point out that
Lojack did not fund their work in any
way nor do they have any financial
stake in Lojack.

chapter summary
1. Graphically, the collective demand curve for
a particular public good can be found by
summing vertically the individual demand
curves for that good. The demand curve
resulting from this process indicates the col-
lective willingness to pay for the last unit of
any given amount of the public good.
2. The optimal quantity of a public good occurs
where the combined willingness to pay for
the last unit—the marginal benefit of the
good—equals the good’s marginal cost.
3. Cost–benefit analysis can provide guidance
as to the economic desirability and most effi-
cient scope of public goods output.
4. Spillovers or externalities cause the equilib-
rium output of certain goods to vary from
the optimal output. Spillover costs (negative
externalities) result in an overallocation of
resources that can be corrected by legisla-
tion or specific taxes. Spillover benefits (pos-
itive externalities) are accompanied by an
underallocation of resources that can be cor-
rected by subsidies to consumers, subsidies
to producers, or government provision.
5. According to the Coase theorem, private bar-
gaining is capable of solving potential exter-
nality problems where (a) the property rights
are clearly defined, (b) the number of people
involved is small, and (c) bargaining costs
are negligible.
6. Clearly established property rights and lia-
bility rules permit some spillover costs to be
prevented or remedied through private law-
suits. Lawsuits, however, can be costly, time-
consuming, and uncertain as to their results.
7. Direct controls and specific taxes can improve
resource allocation in situations where nega-
tive externalities affect many people and
community resources. Both direct controls
(e.g., smokestack emission standards) and
specific taxes (e.g., taxes on firms producing
toxic chemicals) increase production costs
and hence product price. As product price
rises, the externality is reduced, because less
of the output is bought and sold.
8. Markets for pollution rights, where firms can
buy and sell the right to discharge a fixed
amount of pollution, put a price on pollution
and encourage firms to reduce or eliminate it.
9. The socially optimal amount of externality
abatement occurs where society’s marginal
cost and marginal benefit of reducing the
 chapter eighteen • government and market failure 481

externality are equal. This optimal amount of
pollution abatement is likely to be less than
a 100 percent reduction. Changes in technol-
ogy or changes in society’s attitudes toward
pollution can affect the optimal amount of
pollution abatement.
10. The law of conservation of matter and energy
is at the heart of the pollution problem. Mat-
ter can be transformed into other matter or
into energy but cannot disappear. If not re-
cycled, all production will ultimately end up
as waste. Recycling is a recent response to
the growing garbage disposal problem. The
equilibrium price and quantity of recyclable
inputs depend on their demand and supply.
The government can encourage recycling
through either demand or supply incentives.
11. The global warming problem is caused by
excessive accumulation of carbon dioxide
and other greenhouse gases in the earth’s
atmosphere. In the Kyoto Protocol of 1997
the world’s nations agreed to reduce their
emissions of greenhouse gases to 6 to 8 per-
cent below 1990 levels by 2012.
12. Asymmetric information between sellers
and buyers can cause markets to fail. The
moral hazard problem occurs when people
alter their behaviour after they sign a
contract, imposing costs on the other party.
The adverse selection problem occurs when
one party to a contract takes advantage of
the other party’s inadequate information,
resulting in an unanticipated loss to the
latter party.

terms and concepts

cost–benefit analysis, p. 459
marginal cost = marginal
benefit (MC = MB) rule,
p. 461
externalities, p. 461
Coase theorem, p. 462
tragedy of the commons,
p. 466
market for externality rights,
p. 467
optimal reduction of an
externality, p. 470
law of conservation of matter
and energy, p. 470
asymmetric information, p. 474
moral hazard problem, p. 476
adverse selection problem,
p. 477

study questions
1. KEY QUESTION Based on the follow- question 1, and the following supply schedule
ing three individual demand schedules for a to ascertain the optimal quantity of this pub-
particular good, and assuming these three peo- lic good. Why is this the optimal quantity?
ple are the only ones in the society, determine
(a) the market demand schedule on the as- P Qs
sumption that the good is a private good, and
$19 10
(b) the collective demand schedule on the
assumption that the good is a public good. Ex- 16 8
plain the differences, if any, in your schedules. 13 6
10 4
Individual 1 Individual 2 Individual 3
7 2
P Qd P Qd P Qd 4 1

$8 0 $8 1 $8 0 3. KEY QUESTION The following table

7 0 7 2 7 0 shows the total costs and total benefits in bil-
6 0 6 3 6 1 lions for four different antipollution pro-
grams of increasing scope. Which program
5 1 5 4 5 2
should be undertaken? Why?
4 2 4 5 4 3
3 3 3 6 3 4 Program Total cost Total benefit
2 4 2 7 2 5
A $ 3 $ 7
1 5 1 8 1 6
B 7 12
2. KEY QUESTION Use your demand C 12 16
schedule for a public good, determined in D 18 19
482 Part Four • Microeconomics of Government and Public Policy
4. KEY QUESTION Why are spillover
costs and spillover benefits also called
negative and positive externalities? Show
graphically how a tax can correct for a
spillover cost and how a subsidy to produc-
ers can correct for a spillover benefit. How
does a subsidy to consumers differ from
a subsidy to producers in correcting for a
spillover benefit?
5. An apple grower’s orchard provides nectar
to a neighbour’s bees, while the beekeeper’s
bees help the apple grower by pollinating
the apple blossoms. Use Figure 18-2(b) to
explain why this situation might lead to an
underallocation of resources to apple grow-
ing and to beekeeping. How might this
underallocation get resolved via the means
suggested by the Coase theorem?
6. Explain: “Without a market for pollution
rights, dumping pollutants into the air or
water is costless; in the presence of the right
to buy and sell pollution rights, dumping
pollution creates an opportunity cost for the
polluter.” What is the significance of this
opportunity cost to the search for better
technology to reduce pollution?
7. KEY QUESTION Explain the follow-
ing statement using the MB curve in Figure
18-6 to illustrate: “The optimal amount of
pollution abatement for some substances,
say, water from storm drains, is very low; the
optimal amount of abatement for other sub-
stances, say, cyanide poison, is close to 100
percent.”
8. Relate the law of conservation of matter and
energy to (a) the air-pollution problem and
(b) the solid-waste disposal problem. What
is the tragedy of the commons, as it relates
to pollution?
9. What is the global-warming problem? How
is it being addressed? Using an example
other than those given in the text, explain
internet application question
1. Government can use direct controls in the
form of legislation to reduce negative ex-
ternalities such as water pollution. Environ-
ment Canada, <www.ec.gc.ca/envpriorities/
how global warming might hurt one particu-
lar region or country but help another.
10. Explain how marketable emission credits add
to overall economic efficiency, compared to
across-the-board limitations on maximum
discharges of air pollutants by firms.
11. Explain why there may be insufficient re-
cycling of products when the externalities
associated with landfills and garbage incin-
erators are not considered. What demand
and supply incentives might the government
provide to promote more recycling? Explain
how there could be too much recycling in
some situations.
12. Why is it in the interest of new homebuyers
and builders of new homes to have govern-
ment building codes and building inspectors?
13. KEY QUESTION Place an M beside
those items in the following list that describe
a moral hazard problem and an A beside
those that describe an adverse selection
problem.
a. A person with a terminal illness buys
several life insurance policies through
the mail.
b. A person drives carelessly because he or
she has automobile insurance.
c. A person who intends to torch his ware-
house takes out a large fire insurance
policy.
d. A professional athlete who has a guaran-
teed contract fails to stay in shape during
the off-season.
e. A woman who anticipates having a large
family takes a job with a firm that offers
exceptional childcare benefits.
14. (The Last Word) Explain how a global posi-
tioning antitheft device installed by one car
owner can produce a positive spillover to
thousands of others in a city.
cleanwater_e.htm>, is responsible for get-
ting environmental results on clean water.
What success has Environment Canada had?
What is it doing now?
 NINETEEN

Public
Choice
Theory
and the
Economics
of Taxation
IN THIS CHAPTER
Y OU WILL LEARN:

W
hy are so many Canadians disen-
That majority voting
chanted with government? Perhaps
can produce inefficient
voting outcomes. one reason is the apparent failure
• of costly government programs to resolve
Why public sector
failure occurs. socioeconomic ills. For example, despite bil-
• lions of dollars spent on the problems, wide-
The connection between
spread poverty and homelessness in Canada
elasticity and tax incidence.
• persist. And, although per-pupil educational
About the efficiency
spending has dramatically increased in pub-
cost of taxes.
• lic education, the academic performance of
About the Canadian Canadian students on standardized tests
tax system.
compares unfavourably with that of students
in many other nations.
484 Part Four • Microeconomics of Government and Public Policy

Critics charge that government agencies are bogged down in paperwork; that the
public bureaucracy produces trivial regulations and great duplication of effort; that
obsolete programs survive; that various agencies work at cross purposes; that spe-
cial interest groups disproportionately influence Parliament’s decisions; and so on.
Just as there are market failures that impede economic efficiency in the private sec-
tor, it would seem there are government failures that impede economic efficiency in
the public sector. In this chapter we examine some of those impediments. Our two
main topics are (1) public choice theory—the economic analysis of government deci-
sion making—and (2) the economics of taxation. We end the chapter with a brief dis-
cussion of conservative and liberal stances on government and economic freedom.

Revealing Preferences through

Majority Voting
Which public goods should government produce and in what amounts? How
should the tax burden of financing government be apportioned?
Decisions like these are made collectively in Canada through a democratic process
that relies heavily on majority voting. Candidates for office offer alternative policy
packages, and citizens elect the people they think will make the best decisions on
their collective behalf. Voters retire officials who do not adequately represent their
collective wishes. Citizens also periodically have opportunities at the provincial and
municipal levels to vote directly on public expenditures or new legislation.
Although the democratic process does a reasonably good job of revealing soci-
public ety’s preferences, it is imperfect. Public choice theory demonstrates that majority
choice voting can produce inefficiencies and inconsistencies.
theory The
economic analysis
of collective and Inefficient Voting Outcomes
government
decision making.
Society’s well-being is enhanced when government provides a public good whose
total benefit exceeds its total cost. Unfortunately, majority voting does not always
produce that outcome. Voters may defeat a proposal to provide a public good even
though it may yield total benefits that exceed its total cost. Conversely, majority vot-
ing may result in the provision of a public good that costs more than the benefits
it yields.

ILLUSTRATION: INEFFICIENT “NO” VOTE

Assume that the government can provide a public good, say, national defence, at a
total expense of $900. Assume that there are only three individuals—Adams, Ben-
son, and Conrad—in the society and that they will share the $900 tax expense
equally, each being taxed $300 if the proposed public good is provided. And assume,
as Figure 19-1(a) illustrates, that Adams would receive $700 worth of benefits from
having this public good; Benson, $250; and Conrad, $200.
What will be the result if a majority vote determines whether this public good is
provided? Although people do not always vote strictly according to their own eco-
nomic interest, it is likely that Benson and Conrad will vote no because they will
incur tax costs of $300 each while gaining benefits of only $250 and $200, respec-
tively. Adams will vote yes. So the majority vote will defeat the proposal even
though the total benefit of $1150 (= $700 for Adams + $250 for Benson + $200 for
Conrad) exceeds the total cost of $900. Resources should be devoted to this good,
but they will not be, and there will be too little of this public good.
 chapter nineteen • public choice theory and the economics of taxation 485

FIGURE 19-1 INEFFICIENT VOTING OUTCOMES

Majority voting can

Benefit; Tax

Benefit; Tax
produce inefficient Total benefit = $1150
Total cost = $900 Total benefit = $800
decisions. Panel (a): Total cost = $900
Majority voting leads $700
to rejection of a Adams
public good that
would entail a $300 $300
greater total benefit per- per-
than total cost. Panel person person
tax tax $350 $350
(b): Majority voting
results in acceptance $300 $300
of a public good that $250 Benson Conrad
$200
has a higher total Benson
Conrad
cost than total $100
benefit. Adams
(Votes) (Yes) (No) (No)
0 (No) (Yes) (Yes)
0
(a) Inefficient majority "no" vote (b) Inefficient majority "yes" vote

ILLUSTRATION: INEFFICIENT “YES” VOTE

Now consider a situation in which the majority favours a public good even though its
total cost exceeds its total benefit. Figure 19-1(b) shows the details. Again, Adams, Ben-
son, and Conrad will equally share the $900 cost of the public good; they will each be
taxed $300. But since Adams’s benefit now is only $100 from the public good, she will
vote against it. Meanwhile, Benson and Conrad will benefit by $350 each. They will vote
for the public good because that benefit ($350) exceeds their tax payments ($300). The
majority vote will provide a public good costing $900 that produces total benefits of
only $800 (= $100 for Adams + $350 for Benson + $350 for Conrad). Society’s resources
will be inefficiently allocated to this public good, and there will be too much of it.

CONCLUSION
An inefficient outcome may occur as either an overproduction or an underproduc-
tion of a specific public good and, therefore, as an overallocation or underallocation
of resources for that particular use. In Chapter 18 we saw that government can
improve economic efficiency by providing public goods that the market system will
not make available. Now we have extended that analysis to reveal that government
might fail to provide some public goods whose production is economically justifi-
able while providing other goods that are not economically warranted.
In our examples, each person has only a single vote, no matter how much he or
she might gain or lose from a public good. In the first example (inefficient no vote),
Adams would be willing to purchase a vote from either Benson or Conrad if buy-
ing votes were legal. That way Adams could be assured of obtaining the national
defence she so highly values. But since buying votes is illegal, many people with
strong preferences for certain public goods may have to go without them.
When individual consumers have a strong preference for a specific private good,
they usually can find that good in the marketplace even though it may be unpopu-
lar with the majority of consumers. A consumer can buy beef tongue, liver, and
squid in some supermarkets, although it is doubtful that these products would be
available if majority voting stocked the shelves. But a person cannot easily buy a
public good such as national defence once the majority has decided against it.
486 Part Four • Microeconomics of Government and Public Policy

Conversely, a consumer in the marketplace can decide not to buy a particular

product, even a popular one. But although you may not want national defence, you
must “buy” it through your tax payments when it is favoured by the majority.
Because majority voting fails to incorporate the strength of the preferences of the indi-
vidual voter, it may produce economically inefficient outcomes.

Interest Groups and Logrolling

Avenues do exist for resolving the inefficiencies associated with majority voting.
Two examples follow.

INTEREST GROUPS
Those who have a strong preference for a public good may band together into an
interest group and use advertisements, mailings, and direct persuasion to convince
others of the merits of that public good. Adams might try to persuade Benson and
Conrad that it is in their best interest to vote for national defence—that national
defence is much more valuable to them than their $250 and $200 valuations. Such
appeals are common in democratic politics. Sometimes they are successful; some-
times they are not.

POLITICAL LOGROLLING
logrolling Logrolling—the trading of votes to secure favourable outcomes—can also turn an
The trading of votes inefficient outcome into an efficient one. In our first example [Figure 19-1(a)], per-
by legislators to haps Benson has a strong preference for a different public good, for example, a new
secure favourable
outcomes on deci-
road, which Adams and Conrad do not think is worth the tax expense. That would
sions concerning provide an opportunity for Adams and Benson to trade votes to ensure provision of
the provision of both national defence and the new road. That is, Adams and Benson would each
public goods and vote yes on both measures. Adams would get the national defence and Benson
quasipublic goods. would get the road. Without the logrolling, both public goods would have been
rejected. Logrolling will add to society’s well-being if, as was true for national
defence, the road creates a greater overall benefit than cost.
Logrolling need not increase economic efficiency. Even if national defence and the
road each cost more than the total benefit they produced, both might still be pro-
vided because of the vote trading. Adams and Benson might still engage in
logrolling if each expects to secure a sufficient net gain from her or his favoured
paradox public good, even though the gains would come at the clear expense of Conrad.
of voting A Logrolling is very common in provincial legislatures and Parliament. It can either
situation in which increase or diminish economic efficiency, depending on the circumstances.
paired-choice vot-
ing by majority rule
fails to provide a Paradox of Voting
consistent ranking
of society’s prefer-
Another difficulty with majority voting is the paradox of voting, a situation in
ences for public which society may not be able to rank its preferences consistently through paired-
goods or services. choice majority voting.

PREFERENCES
Consider Table 19-1, in which we again assume a community of three voters: Adams,
Benson, and Conrad. Suppose the community has three alternative public goods
from which to choose: national defence, a road, and a severe-weather warning sys-
<www.magnolia.net/
tem. We expect that each member of the community prefers the three alternatives in
~leonf/sd/vp-brf.html> a certain order. For example, one person might prefer national defence to a road, and
The voter’s paradox a road to a severe-weather warning system. We can attempt to determine the prefer-
 chapter nineteen • public choice theory and the economics of taxation 487

ences of the community through paired-choice

TABLE 19-1 PARADOX OF majority voting. Specifically, a vote can be held
VOTING between any two of the public goods, and the
winner of that vote can then be matched against
Preferences
the third public good in another vote.
Public Good Adams Benson Conrad The three goods and the assumed individual
preferences of the three voters are listed in the
National 1st choice 3rd choice 2nd choice top part of Table 19-1. The data indicate that
defence Adams prefers national defence to the road and
Road 2nd choice 1st choice 3rd choice the road to the severe-weather warning system.
Severe- 3rd choice 2nd choice 1st choice This implies also that Adams prefers national
weather defence to the severe-weather warning system.
warning Benson values the road more than the severe-
system weather warning system and the warning sys-
Election Voting outcomes: winner tem more than national defence. Conrad’s order
of preference is severe-weather warning sys-
1. National defence National defence (preferred tem, national defence, and road.
vs. road by Adams and Conrad)
2. Road vs. warning Road (preferred by Adams VOTING OUTCOMES
system and Benson)
The lower part of Table 19-1 shows the out-
3. National defence Warning system (preferred comes of three hypothetical decisions of the
vs. warning system by Benson and Conrad) majority vote. In the first, national defence wins
against the road because a majority of voters
(Adams and Conrad) prefer national defence to
the road. In the second election to see whether this community wants a road or a severe-
weather warning system, a majority of voters (Adams and Benson) prefer the road.
We have determined that the majority of people in this community prefer
national defence to a road and prefer a road to a severe-weather warning system. It
seems logical to conclude that the community prefers national defence to a weather
warning system, but the community does not!
To demonstrate this conclusion, we hold a direct election between national
defence and the warning system. Row (3) shows that a majority of voters (Benson
and Conrad) prefer the severe-weather warning system to national defence. As listed
in Table 19-1, then, the three paired-choice majority votes imply that this community
is irrational: it seems to prefer national defence to a road and a road to a warning sys-
tem, but would rather have a severe-weather warning system than national defence.
The problem is not irrational community preferences but rather a flawed proce-
dure for determining those preferences. We see that the outcome from paired-
choice majority voting may depend on the order in which the votes are taken up.
Under some circumstances majority voting fails to make consistent choices that
reflect the community’s underlying preferences. As a consequence, government
may find it difficult to provide the “correct” public goods by acting in accordance
with majority voting. One important note: this critique is not meant to suggest that
median-
voter model there is some better procedure. Majority voting is much more likely to reflect com-
The theory that munity preferences than decisions made by, say, a dictator or a group of self-
under majority rule appointed leaders. (Key Question 2)
the median (middle)
voter will be in the
dominant position Median-Voter Model
to determine the
outcome of an One final aspect of majority voting reveals insights into real-world phenomena. The
election. median-voter model suggests that, under majority rule and consistent voting
488 Part Four • Microeconomics of Government and Public Policy

preferences, the median voter will in a sense determine the outcomes of elections.
The median voter is the person holding the middle position on an issue: half the
other voters have stronger preferences for a public good, amount of taxation, or
degree of government regulation, and half have weaker or negative preferences. The
extreme voters on each side of an issue prefer the median choice rather than the
other extreme position, so the median voter’s choice predominates.

EXAMPLE
Suppose a society composed of Adams, Benson, and Conrad has reached agreement
that as a society it needs a severe-weather warning system. Each independently is to
submit a total dollar amount he or she thinks should be spent on the warning system,
assuming each will be taxed one-third of that amount. An election will determine the
size of the system. Because each person can be expected to vote for his or her own pro-
posal, no majority will occur if all the proposals are placed on the ballot at the same
time. Thus, the group decides on a paired-choice vote: they will first vote between two
of the proposals and then match the winner of that vote against the remaining proposal.
The three proposals are as follows: Adams desires a $400 system; Benson wants an
$800 system; Conrad opts for a $300 system. Which proposal will win? The median-voter
model suggests it will be the $400 proposal submitted by the median voter, Adams. Half
the other voters favour a more costly system; half favour a less costly system. To under-
stand why the $400 system will be the outcome, let’s conduct the two elections.
First, suppose that the $400 proposal is matched against the $800 proposal.
Adams naturally votes for her $400 proposal, and Benson votes for his own $800
proposal. Conrad, who proposed the $300 expenditure for the warning system,
votes for the $400 proposal because it is closer to his own. So Adams’s $400 proposal
is selected by a 2-to-1 majority vote.
Next, we match the $400 proposal against the $300 proposal. Again the $400 pro-
posal wins. It gets a vote from Adams and one from Benson, who proposed the $800
expenditure and for that reason prefers a $400 expenditure to a $300 one. Adams,
the median voter in this case, is in a sense the person who has decided the level of
expenditure on a severe-weather warning system for this society.

REAL-WORLD APPLICABILITY
Although our illustration is a simple one, it explains a great deal. We do note a ten-
dency for public choices to match most closely the median view. Political candi-
dates, for example, take one set of positions to win the nomination of their political
parties; in so doing, they tend to appeal to the median voter within their party to get
the nomination. They then shift their views more closely to the political centre when
they square off against opponents from the opposite political party. In effect, they
redirect their appeal toward the median voter within the total population. They also
try to label their opponents as being too liberal, or too conservative, and out of touch
with mainstream Canada. They then conduct polls and adjust their positions on
issues accordingly.

IMPLICATIONS
The median-voter model has two important implications:
1. Many people will be dissatisfied by the extent of government involvement in the
economy. The size of government will largely be determined by the median pref-
erence, leaving many people desiring a much larger, or a much smaller, public
sector. In the marketplace you can buy zero zucchinis, two zucchinis, or 200 zuc-
 chapter nineteen • public choice theory and the economics of taxation 489

chinis, depending on how much you enjoy them. In the public sector you get the
number of interprovincial highways the median voter prefers.
2. Some people may “vote with their feet” by moving into political jurisdictions
where the median voter’s preferences are closer to their own. They may move
from the city to a suburb where the level of government services, and therefore
taxes, is lower. Or they may move into an area known for its excellent, but expen-
sive, school system.
For these reasons, and because our personal preferences for government activity are
not static, the median preference shifts over time. Moreover, information about peo-
ple’s preferences is imperfect, leaving much room for politicians to misjudge the
true median position. When they do, they may have a difficult time getting
re-elected. (Key Question 3)

Government Failure
We have seen that the economic results of the marketplace are not always satisfac-
tory and that government actions can help correct them. Economists agree that gov-
ernment has a legitimate function in dealing with instances of market failure. They
advocate the use of cost–benefit analysis to make efficient decisions, including pro-
vision of public goods and services, adjustments for widespread externalities, pro-
visions of appropriate market information, and so on.
But as implied in our discussion of voting problems, government does not always
perform its economic functions effectively and efficiently. Public choice theory
reveals that inherent shortcomings within the public sector can produce inefficient
government outcomes. Such shortcomings may result in government failure—inefficiency
failure Ineffi- because of certain characteristics of the public sector. Let’s consider some of these
ciencies in resource characteristics and outcomes.
allocation caused
by problems in the
operation of the Special Interests and Rent Seeking
public sector
(government). Casual reflection suggests there may be a significant gap between sound economics
and good politics. Sound economics calls for the public sector to pursue various pro-
grams as long as marginal benefits exceed marginal costs. Good politics, however,
suggests that politicians support programs and policies that will maximize their
chance of getting elected and staying in office. The result may be that the in gov-
ernment will promote the goals of groups of voters that have special interests to the
detriment of the larger public. In the process, economic inefficiency may result.

SPECIAL-INTEREST EFFECT
special- Efficient public decision making is often impaired by the special-interest effect.
interest This is any outcome of the political process whereby a small number of people
effect Any obtain a government program or policy that gives them large gains at the expense
result of govern-
ment promotion of
of a much greater number of persons who individually suffer small losses.
the interests (goals) The small group of potential beneficiaries is well informed and highly vocal on
of a small group at the issue in question, and they press politicians for approval. The large numbers fac-
the expense of a ing very small individual losses, however, are generally uninformed on the issue.
much larger group. Politicians feel they will lose the campaign contributions and votes of the small
special-interest group that backs the issue if they legislate against it but will not lose
the support of the large group of uninformed voters, who are likely to evaluate the
politicians on other issues of greater importance to them.
490 Part Four • Microeconomics of Government and Public Policy

The special-interest effect is also evident in so-called pork-barrel politics, a means of

securing a government project that yields benefits mainly to a single political district
and its political representative. In this case, the special-interest group comprises
municipal constituents, while the larger group consists of relatively uninformed tax-
payers scattered across a much larger geographic area. Politicians clearly have a strong
incentive to secure public goods (pork) for their municipal constituents. Such goods
win political favour because they are highly valued by constituents and the much
larger group of relatively uninformed taxpayers bears the cost. Moreover, logrolling
typically enters the picture. “Vote for my special municipal project and I will vote for
yours” becomes part of the overall strategy for securing pork and remaining elected.
Finally, a politician’s inclination to support the smaller group of special benefici-
aries is enhanced because special-interest groups are often quite willing to help
finance the campaigns of right-minded politicians and politicians who bring home
the pork. The result is that politicians may support special-interest programs and
projects that cannot be justified on economic grounds.

RENT-SEEKING BEHAVIOUR
The appeal to government for special benefits at taxpayers’ or someone else’s
rent-seeking expense is called rent seeking. To economists, rent is a payment beyond what is nec-
behaviour essary to keep a resource supplied in its current use. Corporations, trade associa-
The actions by tions, labour unions, and professional organizations employ vast resources to secure
persons, firms, or
unions to gain spe-
favourable government policies that result in rent—higher profit or income than
cial benefits from would occur under competitive market conditions. The government is able to dis-
government at the pense such rent directly or indirectly through laws, rules, hiring, and purchases.
taxpayers’ or some- Elected officials are willing to provide such rent because they want to be responsive
one else’s expense. to key constituents, who in turn help them remain in office.
Here are some examples of “rent-providing” legislation or policies: tariffs on for-
eign products that limit competition and raise prices to consumers; tax breaks that
benefit specific corporations; government construction projects that create union
jobs but cost more than the benefits they yield; occupational licensing that goes
beyond what is needed to protect consumers; and large subsidies to farmers by tax-
payers. None of these is justified by economic efficiency.

Clear Benefits, Hidden Costs

Some critics say that vote-seeking politicians will not weigh objectively all the costs and
benefits of various programs, as economic rationality demands, in deciding which to
support and which to reject. Because political officeholders must seek voter support
every few years, they favour programs that have immediate and clear-cut benefits and
vague or deferred costs. Conversely, politicians will reject programs with immediate
and easily identifiable costs but with less measurable and very high long-term benefits.
Such biases may lead politicians to reject economically justifiable programs and
to accept programs that are economically irrational. For example, a proposal to con-
struct or expand mass-transit systems in large metropolitan areas may be econom-
ically rational on the basis of benefit–cost analysis, but if (1) the program is to be
financed by immediate increases in highly visible income or sales taxes and (2) ben-
efits will occur only years from now when the project is completed, then the vote-
seeking politician may oppose the program.
Conversely, assume that a program of federal transfers to municipal police forces
is not justifiable on the basis of benefit–cost analysis. But if the cost is paid for from
budget surpluses, the program’s modest benefits may seem so large that it will gain
approval.
chapter nineteen • public choice theory and the economics of taxation 491

Limited and Bundled Choice

Public choice theorists point out that the political process forces citizens and their
elected representatives to be less selective in choosing public goods and services
than they are in choosing private goods and services.
In the marketplace, the citizen as a consumer can exactly satisfy personal prefer-
ences by buying certain goods and not buying others. However, in the public sector the
citizen as a voter is confronted with, say, only two or three candidates for an office, each
representing a different bundle of programs (public goods and services). None of these
bundles of public goods is likely to fit exactly the preferences of any particular voter,
yet the voter must choose one of them. The candidate who comes closest to voter
Smith’s preference may endorse national health insurance, increases in Old Age Secu-
rity benefits, subsidies to tobacco farmers, and tariffs on imported goods. Smith is
likely to vote for that candidate even though Smith strongly opposes tobacco subsidies.
In other words, the voter must take the bad with the good. In the public sector,
people are forced to “buy” goods and services they do not want. It is as if, in going
to a sporting-goods store, you were forced to buy an unwanted pool cue to get a
wanted pair of running shoes. This is a situation where resources are not being used
efficiently to satisfy consumer wants. In this sense, the provision of public goods
and services is inherently inefficient.
Parliament is confronted with a similar limited-choice, bundled-goods problem.
Appropriations legislation combines hundreds, even thousands, of spending items
into a single bill. Many of these spending items may be completely unrelated to the
main purpose of the legislation, yet members of Parliament must vote the entire
package—yea or nay. Unlike consumers in the marketplace, they cannot be selec-
tive. (Key Question 4)

Bureaucracy and Inefficiency

Some economists contend that public agencies are generally less efficient than pri-
vate businesses. The reason is not that lazy and incompetent workers somehow end
up in the public sector while ambitious and capable people gravitate to the private
sector. Rather, it is that the market system creates incentives and pressures for inter-
nal efficiency that are absent from the public sector. Private enterprises have a clear
goal—profit. Whether a private firm is in a competitive or monopolistic market, effi-
cient management means lower costs and higher profit. The higher profit not only
benefits the firm’s owners but enhances the promotion prospects of managers. Part
of the managers’ pay may be tied to profit via profit-sharing plans, bonuses, and
stock options. There is no similar gain to government agencies and their man-
agers—no counterpart to profit—to create a strong incentive to achieve efficiency.
The market system imposes a very obvious test of performance on private firms:
the test of profit and loss. An efficient firm is profitable and therefore successful; it
survives, prospers, and grows. An inefficient firm is unprofitable and unsuccessful;
it declines and in time goes bankrupt and ceases to exist. But no similar, clear-cut
test exists with which to assess the efficiency or inefficiency of public agencies. How
can anyone determine whether a public hydroelectricity provider, a provincially
funded university, a municipal fire department, the Department of Agriculture, or
the Bureau of Indian Affairs is operating efficiently?
Cynics even argue that a public agency that inefficiently uses its resources is likely
to survive and grow! In the private sector, inefficiency and monetary loss lead to the
abandonment of certain activities, products, or even firms. But the government, they
say, does not like to abandon activities in which it has failed. Some suggest that the
492 Part Four • Microeconomics of Government and Public Policy

typical response of the government to a program’s failure is to increase its budget

and staff, which means that public sector inefficiency just continues on a larger scale.
Furthermore, economists assert that government employees, together with the
special-interest groups they serve, often gain sufficient political clout to block
attempts to pare down or eliminate their agencies. Politicians who attempt to reduce
the size of huge federal bureaucracies such as those relating to agriculture, educa-
tion, health and welfare, and national defence incur sizable political risk because
bureaucrats and special-interest groups will team up to defeat them.
Finally, critics point out that there is a tendency for government bureaucrats to
justify their continued employment by looking for and eventually finding new
“problems” to solve. It is not surprising that social problems, as defined by gov-
ernment, tend to persist or even expand.

Imperfect Institutions
It is possible to argue that such criticisms of public sector inefficiency are exagger-
ated and cynical. Perhaps they are. Nevertheless, they do tend to shatter the concept
of a benevolent government that responds with precision and efficiency to the wants
of its citizens. The market system of the private sector is far from perfectly efficient,
and government’s economic function is mainly to correct that system’s shortcom-
ings. But the public sector too is subject to deficiencies in fulfilling its economic func-
tion. “The relevant comparison is not between perfect markets and imperfect
governments, nor between faulty markets and all-knowing, rational, benevolent
governments, but between inevitably imperfect institutions.”1
Because the market system and public agencies are both imperfect, it is some-
times difficult to determine whether a particular activity can be performed with
greater success in the private sector or the public sector. It is easy to reach agreement
on opposite extremes: national defence must lie with the public sector, while com-
puter production can best be accomplished by the private sector. But what about
health insurance? parks and recreation areas? fire protection? garbage collection?
housing? education? It is hard to assess every good or service and to say absolutely
that it should be assigned to either the public sector or the private sector. After all,
the goods and services just mentioned are provided in part by both private enter-
prises and public agencies.

● Majority voting can produce voting outcomes
that are inefficient; projects having greater total
benefits than total costs may be defeated and
projects having greater total costs than total
benefits may be approved.
● The paradox of voting occurs when voting by
majority rule does not provide a consistent
ranking of society’s preferences for public goods
and services.
● The median-voter model suggests that under
majority rule and consistent voting preferences,
the voter who has the middle preference will
determine the outcome of an election.
● Public sector failure allegedly occurs as a result
of rent-seeking, pressure by special-interest
groups, shortsighted political behaviour, lim-
ited and bundled choices, and bureaucratic
inefficiency.

1
Otto Eckstein, Public Finance, 3rd ed. (Englewood Cliffs, N.J.: Prentice-Hall, 1973), p. 17.
 chapter nineteen • public choice theory and the economics of taxation 493

Apportioning the Tax Burden

We now turn from the difficulties of making collective decisions about public goods
The Role of
Governments to the difficulties of deciding how those goods should be financed.
It is difficult to measure precisely how the benefits of public goods are appor-
tioned among individuals and institutions. We cannot accurately determine how
much citizen Raheed Singh benefits from military installations, a network of high-
ways, a public school system, the national weather bureau, and municipal police
and fire protection.
The situation is different when it comes to paying for those benefits. Studies
<n103dept.matc.edu/ reveal with reasonable clarity how the overall tax burden is apportioned. (By “tax
walshj/handouts/
goodtax.htm>
burden” we mean the total cost of taxes imposed on society.) This apportionment
Principles of a question affects each of us. The overall level of taxes is important, but the average
good tax citizen is much more concerned with his or her part of the overall tax burden.

Benefits Received versus Ability to Pay

There are two basic philosophies on how the economy’s tax burden should be
apportioned.

BENEFITS-RECEIVED PRINCIPLE
benefits- The benefits-received principle of taxation asserts that households and businesses
received should purchase the goods and services of government in the same way they buy
principle other commodities. Those who benefit most from government-supplied goods or
The idea that those
who receive the
services should pay the taxes necessary to finance them. A few public goods are now
benefits of goods financed on this basis. For example, money collected as gasoline taxes is typically
and services pro- used to finance some highway construction and repairs. Thus people who benefit
vided by govern- from good roads pay the cost of those roads. Difficulties immediately arise, how-
ment should pay ever, when we consider widespread application of the benefits-received principle.
the taxes required
to finance them. ● How will the government determine the benefits that individual households
and businesses receive from national defence, education, the court system, and
police and fire protection? Recall that public goods provide widespread
spillover benefits and that the exclusion principle does not apply. Even in the
seemingly straightforward case of highway financing, it is difficult to measure
benefits. Owners of cars benefit in different degrees from good roads, but oth-
ers also benefit. For example, businesses benefit because good roads bring
them customers.
● The benefits-received principle cannot logically be applied to income redistri-
bution programs. It would be absurd and self-defeating to ask poor families to
pay the taxes needed to finance their welfare payments. It would be ridiculous
to think of taxing only unemployed workers to finance the unemployment
ability- compensation payments they receive.
to-pay
principle ABILITY-TO-PAY PRINCIPLE
The idea that those
who have greater The ability-to-pay principle of taxation asserts that the tax burden should be appor-
income (or wealth) tioned according to taxpayers’ income and wealth. In Canada this means that indi-
should pay a viduals and businesses with larger incomes should pay more taxes in both absolute
greater proportion
of it as taxes than
and relative terms than those with smaller incomes.
those who have less What is the rationale of ability-to-pay taxation? Proponents argue that each addi-
income (or wealth). tional dollar of income received by a household yields a smaller amount of satisfaction
494 Part Four • Microeconomics of Government and Public Policy

or marginal utility when it is spent. Because consumers act rationally, the first dol-
lars of income received in any period will be spent on high-urgency goods that yield
the greatest marginal utility. Successive dollars of income will go for less urgently
needed goods and finally for trivial goods and services. This process means that a
dollar taken through taxes from a poor person who has few dollars represents a
greater utility sacrifice than a dollar taken through taxes from a rich person who has
many dollars. To balance the sacrifices that taxes impose on income receivers, taxes
should be apportioned according to the amount of income a taxpayer receives.
This argument is appealing, but application problems arise here, too. Although
we might agree that the household earning $100,000 per year has a greater ability to
pay taxes than a household receiving $10,000, we don’t know exactly how much
more ability to pay the first family has. Should the wealthier family pay the same
percentage of its larger income, and hence a larger absolute amount, as taxes? Or
should it be made to pay a larger fraction of its income as taxes? How much larger
should that fraction be?
There is no scientific way of measuring someone’s ability to pay taxes—and that’s
the main problem. In practice, the solution hinges on guesswork, the tax views of the
political party in power, expediency, and how urgently the government needs revenue.

Progressive, Proportional, and Regressive Taxes

Any discussion of taxation leads ultimately to the question of tax rates. Note that an
average tax rate is the total tax paid divided by some base against which the tax is
compared.

DEFINITIONS
Taxes are classified as progressive, proportional, or regressive, depending on the
relationship between average tax rates and taxpayer incomes. We focus on incomes
progressive because all taxes, whether on income or on a product or a building or a parcel of
tax A tax whose
average tax rate land, are ultimately paid out of someone’s income.
increases as the
taxpayer’s income
● A tax is progressive if its average rate increases as income increases. Such a tax
increases and claims not only a larger absolute (dollar) amount but also a larger percentage
decreases as the of income as income increases.
taxpayer’s income
decreases. ● A tax is regressive if its average rate declines as income increases. Such a tax
takes a smaller proportion of income as income increases. A regressive tax may
regressive or may not take a larger absolute amount of income as income increases. (You
tax A tax whose may want to derive an example to substantiate this conclusion.)
average tax rate
decreases as the ● A tax is proportional if its average rate remains the same regardless of the size
taxpayer’s income of income.
increases and
decreases as the We can illustrate these ideas with the personal income tax. Suppose tax rates are
taxpayer’s income such that a household pays 10 percent of its income in taxes regardless of the size of
decreases.
its income. This is a proportional income tax. Now suppose the rate structure is such
propor- that a household with an annual taxable income of less than $10,000 pays 5 percent
tional tax A in income taxes; a household with an income of $10,000 to $20,000 pays 10 percent;
tax whose average one with a $20,000 to $30,000 income pays 15 percent; and so forth. This is a pro-
tax rate remains gressive income tax.
constant as the
taxpayer’s income
Finally, suppose the rate declines as taxable income rises: you pay 15 percent if
increases or you earn less than $10,000; 10 percent if you earn $10,000 to $20,000; 5 percent if you
decreases. earn $20,000 to $30,000; and so forth. This is a regressive income tax.
 chapter nineteen • public choice theory and the economics of taxation 495

In general, progressive taxes are those that fall

TABLE 19-2 TAX REVENUE relatively more heavily on those with high in-
SOURCES OF comes; regressive taxes are those that fall rela-
CANADIAN tively more heavily on the poor. (Key Question 7)
GOVERNMENTS,
1997–98 APPLICATIONS
Billions of Percent Let’s examine the progressivity, or regressivity,
dollars of GDP of several taxes. In Table 19-2 you will find the
yields of the main taxes in Canada and what
Personal income taxes 160.2 16.7 these yields are as a percentage of gross domes-
Corporation income taxes 33.9 3.5 tic product.
Sales taxes 73.1 7.6
Personal Income Tax The federal personal in-
Property and related taxes 35.6 4.0 come tax is progressive, with marginal tax rates
Other taxes 70.7 7.4 (those assessed on additional income) ranging
Total tax revenues 373.5 39.2 from 17 to 29 percent. In 2000 the federal in-
Source: Statistics Canada, <www.statcan.ca/english/
come tax was 17 percent on the first $30,004;
Pgdb/State/Government/govt01a.htm>, 1999. 26 percent for income between $30,005 and
Visit www.mcgrawhill.ca/college/mcconnell9 for data update. $60,008; and 29 percent for income above $60,009.
Rules that allow individuals to deduct from
income contributions to their registered retire-
ment saving plan (RRSP) tend to make the tax less progressive than these marginal
rates suggest. Nevertheless, average tax rates rise with income. Table 19-2 shows
that the personal income tax is by far the largest source of government revenue.
Sales Taxes At first thought, a general sales tax with, for example, a 5 percent rate
would seem to be proportional, but in fact it is regressive with respect to income. A
larger portion of a low-income person’s income is exposed to the tax than is the case
for a high-income person; the rich pay no tax on the part of income that is saved,
whereas the poor are unable to save. For example, “Low-income” Goldstein has an
income of $15,000 and spends it all. “High-income” Jones has an income of $300,000
but spends only $200,000 and saves the rest. Assuming a 5 percent sales tax applies
to all expenditures of each individual, we find that Goldstein pays $750 (5 percent
of $15,000) in sales taxes and Jones pays $10,000 (5 percent of $200,000). But Gold-
stein pays $750/$15,000 or 5 percent of income as sales taxes, while Jones pays
$10,000/$300,000 or 3.3 percent of income as sales tax. The general sales tax, there-
fore, is regressive.
<sbinfocanada.about.com/ Corporate Income Tax The federal corporate income tax is essentially a proportional
aboutcanada/ tax with a flat 28 percent tax rate in 2000. But this assumes that corporation owners
sbinfocanada/library/
weekly/aa032101a.htm>
(shareholders) bear the tax. Some tax experts argue that at least part of the tax is
Provincial tax comparison passed through to consumers in the form of higher product prices. To the extent that
for small businesses this occurs, the tax is like a sales tax and is thus regressive.

Property Taxes Most economists conclude that property taxes on buildings are
regressive for the same reasons as are sales taxes. First, property owners add the tax
to the rents that tenants are charged. Second, property taxes, as a percentage of
income, are higher for low-income families than for high-income families because
the poor must spend a larger proportion of their incomes for housing. This alleged
regressivity of property taxes may be increased by differences in property-tax rates
from municipality to municipality. In general, property-tax rates are higher in
poorer areas to make up for lower property values.
496 Part Four • Microeconomics of Government and Public Policy

Tax Incidence and Efficiency Loss

Determining whether a particular tax is progressive, proportional, or regressive is
complicated, because those on whom taxes are levied do not always pay the taxes.
tax inci- We, therefore, need to try to locate the final resting place of a tax, or the tax inci-
dence The dence. The tools of elasticity of supply and demand will help. Let’s focus on a hypo-
person or group thetical excise tax levied on wine producers. Do the producers really pay this tax, or
who ends up paying
a tax.
do they shift it to wine consumers?

Elasticity and Tax Incidence

In Figure 19-2, S and D represent the pretax market for a certain domestic wine; the
no-tax equilibrium price and quantity are $4 per bottle and 15 million bottles. Sup-
pose that government levies an excise tax of $1 per bottle at the winery. Who will
actually pay this tax?

DIVISION OF BURDEN
Since the government imposes the tax on the sellers (suppliers), we can view the tax
as an addition to the marginal cost of the product. Now sellers must get $1 more for
each bottle to receive the same per-unit profit they were getting before the tax. While
sellers are willing to offer, for example, five million bottles of untaxed wine at $2 per
bottle, they must now receive $3 per bottle (= $2 plus the $1 tax) to offer the same
five million bottles. The tax shifts the supply curve upward (leftward) as shown in
Figure 19-2, where St is the after-tax supply curve.
The after-tax equilibrium price is $4.50 per bottle, whereas the before-tax equi-
librium price was $4. So, in this case, consumers pay half the $1 tax as a higher price;

FIGURE 19-2 THE INCIDENCE OF AN EXCISE TAX

An excise tax of a speci- P
fied amount, here $1 per
unit, shifts the supply St
curve upward by the
S
amount of the tax per
unit: the vertical dis- $6
tance between S and St.
Tax $1
Price (per bottle)

This results in a higher

5
price (here $4.50) to
consumers and a lower
after-tax price (here 4
$3.50) to producers.
Thus consumers and
producers share the 3
burden of the tax in
some proportion (here 2
equally at $.50 per unit).
D
1

0
5 10 15 20 25 Q
Quantity
(millions of bottles per month)
 chapter nineteen • public choice theory and the economics of taxation 497

producers pay the other half in the form of a lower after-tax per-unit revenue. That
is, after remitting the $1 tax per unit to government, producers receive $3.50, or 50
cents less than the $4 before-tax price. So, in this case, consumers and producers
share the burden of the tax equally: producers shift half the tax to consumers in the
form of a higher price and bear the other half themselves.
Note also that the equilibrium quantity declines because of the tax levy and the
higher price that it imposes on consumers. In Figure 19-2 that decline in quantity is
from 15 million bottles to 12.5 million bottles per month.

ELASTICITIES
If the elasticities of demand and supply were different from those shown in Figure
19-2, the incidence of tax would also be different. Two generalizations are relevant.
First, with a specific supply, the more inelastic the demand for the product, the larger is
the portion of the tax shifted to consumers. To verify this, sketch graphically the extreme
cases in which demand is perfectly elastic and perfectly inelastic. In the first case,
the incidence of the tax is entirely on sellers; in the second, the tax is shifted entirely
to consumers.
Figure 19-3 contrasts the more usual cases where demand is either relatively elas-
tic or relatively inelastic in the relevant price range. With elastic demand in panel (a),
a small portion of the tax (Pe – P1) is shifted to consumers, and most of the tax (P1 – Pa)
is borne by the producers. With inelastic demand in panel (b), most of the tax (Pi – P1)
is shifted to consumers, and only a small amount (P1 – Pb) is paid by producers. In both
graphs the per-unit tax is represented by the vertical distance between St and S.
Note also that the decline in equilibrium quantity (Q1 – Q2) is smaller when
demand is more inelastic. This is the basis of our previous applications of the elas-
ticity concept: Revenue-seeking legislatures place heavy excise taxes on liquor, cig-
arettes, automobile tires, telephone service, and other products whose demand is
thought to be inelastic. Since demand for these products is relatively inelastic, the
tax does not reduce sales by much, so the tax revenue stays high.
Second, with a specific demand, the more inelastic the supply, the larger is the portion
of the tax borne by producers. When supply is elastic [Figure 19-4(a)], the producers

FIGURE 19-3 DEMAND ELASTICITY AND THE INCIDENCE OF AN

EXCISE TAX
Panel (a): If demand P P
St St
is elastic in the rele-
vant price range, Tax S Tax S
price rises modestly
(P1 to Pe) when an
excise tax is levied. Pi a
Pe a
Hence, the producer
P1 P1
bears most of the tax b b
burden. Panel (b): If De Pb
Pa c
demand is inelastic, c
the price to the buyer
increases substan- Di
tially (P1 to Pi) and 0 Q2 Q1 Q 0 Q2 Q1 Q
most of the tax is
shifted to consumers. (a) Tax incidence and elastic (b) Tax incidence and inelastic
demand demand
498 Part Four • Microeconomics of Government and Public Policy

shift most of the tax (Pe – P1) to consumers and bear only a small portion (P1 – Pa)
themselves. But where supply is inelastic [Figure 19-4(b)], the reverse is true: the
major portion of the tax (P1 – Pb) falls on sellers, and a relatively small amount
(Pi – P1) is shifted to buyers. The equilibrium quantity also declines less with an
inelastic supply than it does with an elastic supply.
Gold is an example of a product with an inelastic supply and one where the bur-
den of an excise tax (such as an extraction tax) would mainly fall on producers. Con-
versely, because the supply of baseballs is relatively elastic, producers would pass
on to consumers much of an excise tax on baseballs.

Efficiency Loss of a Tax

We just observed that producers and consumers typically each bear part of an excise
tax levied on producers. Let’s now look more closely at the overall economic effect
of the excise tax. Consider Figure 19-5, which is identical to Figure 19-2 but contains
the additional detail we need for our discussion.

TAX REVENUES
In our example, a $1 excise tax on wine increases its market price from $4 to $4.50
per bottle and reduces the equilibrium quantity from 15 million bottles to 12.5 mil-
lion. Government tax revenue is $12.5 million (= $1 × 12.5 million bottles), an
amount shown as the rectangle efac in Figure 19-5. The elasticities of supply and
demand in this case are such that consumers and producers each pay half this total
amount, or $6.25 million apiece (= $.50 × 12.5 million bottles). The government uses
this $12.5 million of tax revenue to provide public goods and services. So this trans-
fer of dollars from consumers and producers to government involves no loss of
well-being to society.

EFFICIENCY LOSS
The $1 tax on wine does more than require consumers and producers to pay $12.5
million in taxes; it also reduces the equilibrium amount of wine produced and

FIGURE 19-4 SUPPLY ELASTICITY AND THE INCIDENCE OF AN

EXCISE TAX
Panel (a): With elastic P P
St S
supply, an excise tax
results in a large
price increase (P1 to St
Pe), and the tax is, Tax Tax
therefore, paid mainly a
by consumers. Panel Pe
S a
(b): If supply is inelas- P1 b Pi
tic, the price rise is Pa P1 b
c
small (P1 to Pi), and Pb c
sellers bear most of
the tax. D
D
0 Q2 Q1 Q 0 Q2 Q 1 Q
(a) Tax incidence and elastic (b) Tax incidence and inelastic
supply supply
 chapter nineteen • public choice theory and the economics of taxation 499

FIGURE 19-5 EFFICIENCY LOSS OF A TAX

The levy of a $1 tax P
per bottle of wine St
Tax paid
increases the price by consumers
per bottle from $4 to $6
S
$4.50 and reduces the
equilibrium quantity
from 15 million to 12.5 5
f a Tax $1

Price (per bottle)

million. Tax revenue
to the government is
4 b
$12.5 million (area
efac). The efficiency c
e
loss of the tax arises 3
from the 2.5 million
decline in output; Efficiency
the amount of that loss
2
loss is shown as
triangle abc. Tax paid
by producers D
1

0 5 10 15 20 25 Q
Quantity
(millions of bottles per month)

consumed by 2.5 million bottles. The fact that consumers and producers demanded
and supplied 2.5 million more bottles of wine before the tax means that those
2.5 million bottles provided benefits in excess of their production costs. This is clear
from the following analysis.
Segment ab of demand curve D in Figure 19-5 indicates the willingness to pay—the
marginal benefit—associated with each of the 2.5 million bottles consumed before
(but not after) the tax. Segment cb of supply curve S reflects the marginal cost of each
bottle of wine. For all but the very last one of these 2.5 million bottles, the marginal
benefit (shown by a point on ab) exceeds the marginal cost (shown by a point on cb).
Not producing all 2.5 million bottles of wine reduces well-being by an amount repre-
efficiency sented by the triangle abc. The area of this triangle identifies the efficiency loss of the
loss of a tax (also called the deadweight loss of the tax). This loss is society’s sacrifice of net ben-
tax The loss of efit, because the tax reduces production and consumption of the product below their
net benefits to soci-
ety because a tax
levels of economic efficiency at which marginal benefit and marginal cost are equal.
reduces the produc-
tion and consump- ROLE OF ELASTICITIES
tion of a taxed good Most taxes create some degree of efficiency loss, but just how much depends on the
below the level of
allocative efficiency.
supply and demand elasticities. Glancing back at Figure 19-3, we see that the effi-
ciency loss area abc is greater in panel (a), where demand is relatively elastic, than
in panel (b), where demand is relatively inelastic. Similarly, area abc is greater in
panel (a) of Figure 19-4 than in panel (b), indicating a larger efficiency loss where
supply is more elastic. Other things equal, the greater the elasticities of supply and
demand, the greater the efficiency loss of a particular tax.
Two taxes yielding equal revenues do not necessarily impose equal costs on soci-
ety. The government must keep this fact in mind when designing a tax system to
500 Part Four • Microeconomics of Government and Public Policy

finance beneficial public goods and services. In general, government should mini-
mize the efficiency loss of the tax system in raising any specific dollar amount of tax
revenue.

QUALIFICATIONS
We must acknowledge, however, that there may be other tax goals as important, or
even more important, than minimizing efficiency losses from taxes. Here are two
examples:
1. Redistributive goals Government may want to impose progressive taxes as a
way to redistribute income. A 10 percent excise tax placed on selected luxuries
would be an example. Because the demand for luxuries is elastic, substantial effi-
ciency losses from this tax are to be expected. However, if government concluded
that the benefits from the redistribution effects of the tax would exceed the effi-
ciency losses, then it would levy the luxury tax.
2. Reducing negative externalities The government may have intended the $1 tax
on wine in Figure 19-5 to reduce the consumption of wine by 2.5 million bottles. It
may have concluded that such consumption of alcoholic beverages produces cer-
tain negative externalities. Therefore, it might have purposely levied this tax to
shift the market supply curve such that the price of wine increased and the amount
of resources allocated to wine declined, as in Figure 19-3(b). (Key Question 9)

Probable Incidence of Taxes in Canada

Let’s look now at the probable incidence of each of the major sources of tax revenue
in Canada.

PERSONAL INCOME TAX

The incidence of the personal income tax generally is on the individual because
there is little chance for shifting it. But there might be exceptions. Individuals and
groups who can control the price of their labour services may be able to shift a part
of the tax. Dentists, lawyers, and other professional people who can readily increase
their fees may do so because of the tax. Unions might regard personal income taxes
as part of the cost of living and, as a result, strengthen their bargaining resolve for
higher wages when personal income tax rates rise. If they are successful, they may
shift part of the tax from workers to employers, who, by increasing prices, shift the
wage increase to the public. Generally, however, the individual on whom the tax is
initially levied bears the burden of the personal income tax.

CORPORATE INCOME TAX

The incidence of the corporate income tax is much less certain. The traditional view
is that a firm currently charging the profit-maximizing price and producing the
profit-maximizing output will have no reason to change price or output when a tax
on corporate income (profit) is imposed. The price and output combination yield-
ing the greatest profit before the tax will still yield the greatest profit after a fixed
percentage of the firm’s profit is taken away via an income tax. In this view, the com-
pany’s stockholders (owners) must bear the burden of the tax through lower divi-
dends or a smaller amount of retained earnings.
However, economists recognize that where a small number of firms control a
market, producers may be able to shift part of their corporate income tax to con-
sumers through higher prices and to resource suppliers through lower prices and
 chapter nineteen • public choice theory and the economics of taxation 501

wages. That is, some firms may be able to use their monopoly power as product sell-
ers and monopsony power as resource buyers to reduce the actual amount of the tax
paid by their corporate stockholders.
There is no consensus among experts on the overall incidence of the corporate
income tax. Stockholders, customers, and resource suppliers may share the tax bur-
den in some unknown proportion.

SALES AND EXCISE TAXES

A sales tax is a general excise tax levied on a wide range of consumer goods and serv-
ices, whereas a specific excise tax is one levied only on a particular product. Sales taxes
are usually transparent to the buyer, whereas excise taxes are often hidden in the price
of the product. An example of a general sales tax is the federal Goods and Services Tax
(GST) which is levied on most goods and services sold across Canada. Sellers often
shift both kinds of taxes partly or largely to consumers through higher product prices.
There may be some difference in the extent to which sales taxes and excise taxes are
shifted, however. Because a sales tax covers a much wider range of products than an
excise tax does, consumers have little chance to resist the price boosts that sales taxes
entail. They cannot reallocate their expenditures to untaxed, lower-priced products.
Therefore, sales taxes tend to be shifted from producers in their entirety to consumers.
Excise taxes, however, fall on a select list of goods. Therefore, the possibility of
consumers turning to substitute goods and services is greater. An excise tax on the-
atre tickets that does not apply to other types of entertainment might be difficult to
pass on to consumers via price increases. Why? The answer is provided in Figure
19-3(a), where demand is elastic. A price boost to cover the excise tax on theatre tick-
<www.taxpayer.com/ ets might cause consumers to substitute alternative types of entertainment. The
opinioneditorials/
nationalpost/
higher price would reduce sales so much that a seller would be better off to bear all,
jan5-1999.htm> or a large portion of, the excise tax. (See Global Perspective 19.1 for a comparison of
Gasoline and taxes taxes on goods and services in various countries.)

19.1

Taxes on Goods and Services

Taxes on goods and (Percentage of Total Tax Receipts)
services as a percentage 0 5 10 15 20 25 30 35
of total tax revenues,
selected nations Britain
Netherlands
Compared with our major trad-
France
ing partner, the United States,
Germany
Canada relies more heavily on
goods and services taxes—sales Italy
taxes, value-added taxes, and Canada
specific excise taxes. (A value- Sweden
added tax applies only to the United States
difference between the value
Japan
of a firm’s sales and the value of
its purchases from other firms.) Source: Organisation for Economic Co-operation
and Development data, <www.oecd.org/>.
502 Part Four • Microeconomics of Government and Public Policy

With other products, modest price increases to cover taxes may have smaller
effects on sales. The excise taxes on gasoline, cigarettes, and alcoholic beverages pro-
vide examples—for these products few good substitutes exist to which consumers
goods and can turn as prices rise. For these goods, the seller is better able to shift nearly all the
services tax excise tax to consumers; prices of cigarettes have gone up nearly in lockstep with the
(gst) Federal tax recent, substantial increases in excise taxes on cigarettes.
that replaced the
federal sales tax in PROPERTY TAXES
Canada; it is 7 per-
cent on a broad Many property taxes are borne by the property owner because there is no other
base of goods and party to whom they can be shifted. This is typically true for taxes on land, personal
services (the only property, and owner-occupied residences. Even when land is sold, the property tax
exemptions are agri- is not likely to be shifted. The buyer understands that future taxes will have to be
cultural and fish
products, prescrip-
paid on it, and this expected taxation will be reflected in the price the buyer is will-
tion drugs, and ing to offer for the land.
medical devices); Taxes on rented and business property are a different story. Taxes on rented prop-
businesses remit the erty can be, and usually are, shifted wholly or in part from the owner to the tenant
difference between by the process of boosting the rent. Business property taxes are treated as a business
the value of their
sales and the value
cost and are taken into account in establishing product price; hence, such taxes are
of their purchases ordinarily shifted to the firm’s customers.
from other firms. Table 19-3 summarizes this discussion of the shifting and incidence of taxes.

Recent Canadian Tax Reform

The Canadian tax system has undergone two major changes within the past two
decades: (1) the 1987 Tax Reform and (2) the Goods and Services Tax (GST). Keep
in mind that we refer to the federal government only; each province also levies
taxes, some in conjunction with the federal government.

The 1987 Tax Reform

Spurred on by the tax reform in the United States that significantly lowered mar-
<www.ctf.ca>
ginal tax rates, the Canadian government simplified the personal income tax from
Canadian Tax 11 categories to only 3. The result was a lower marginal tax rate, which, combined
Foundation with provincial levies, had been as high as 64 percent. The tax reforms also eliminated

TABLE 19-3 THE PROBABLE INCIDENCE OF TAXES

Type of tax Probable incidence

Personal income tax The household or individual on which it is levied.

Corporate income tax Some economists conclude the firm on which it is levied bears the tax;
others conclude the tax is shifted, wholly or in part, to consumers and
resource suppliers.
Sales tax Consumers who buy the taxed products.
Specific excise taxes Consumers, producers, or both, depending on elasticities of demand and
supply.
Property taxes Owners in the case of land and owner-occupied residences; tenants in the
case of rented property; consumers in the case of business property.
 chapter nineteen • public choice theory and the economics of taxation 503

tax deductions in favour of tax credits. The top federal marginal tax rate has come
down to about 45 percent.
Subsequent to these reforms the federal surtax was increased and a claw-back
provision was introduced that in effect took back part of the social insurance bene-
fits, primarily employment insurance and family allowance, paid to higher income
Canadians. Both of these provisions made the income tax system more progressive.

The GST
The controversy surrounding the introduction of the GST was unprecedented.
Much of the dispute arose because of misunderstandings and a concerted and
highly publicized effort by the official opposition in Parliament, the Liberal Party,
to defeat the legislation.
value added The GST is similar to a value-added tax (VAT). It is much like a sales tax, except
tax (vat) A tax that it applies only to the difference between the value of a firm’s sales and the value
imposed on the dif- of its purchases from other firms. Firms are allowed a tax credit equal to the taxes
ference between the
value of the prod-
paid on their inputs. Most European nations currrently use VATs as a source of rev-
ucts sold by a firm enue (see Global Perspective 19.1).
and the value of the The GST replaced the federal sales tax, which was levied primarily on manufac-
goods purchased tured goods and was as high as 13 percent on some products. The GST at present
from other firms stands at 7 percent and is levied on a much broader base that includes both goods
to produce the
product.
and services. The only exemptions are agricultural and fish products, prescription
drugs, and medical devices.
An important feature of the GST is that exports are exempt since producers can
claim a credit equal to the taxes paid on the inputs used to produce the product.
Moreover, imported goods are subject to the GST, so they do not have an advantage
compared to domestically produced goods.

Reforms of 2000
In the federal government budget of February 2000, major changes to the tax sys-
tem were announced. The most important features are
● Full indexation of the personal income tax system to protect taxpayers against
automatic tax increases caused by inflation.
● The reduction of the middle income tax rate to 23 from 26 percent over five years.
● The reduction of the corporate income tax rate to 21 percent from 28 percent
on small business income.
● The reduction of the capital gains tax.
● The elimination of the 5 percent deficit reduction surtax on middle-income
taxpayers.
The federal government claims that over five years, the year 2000 tax reforms will
save Canadians some $58 billion in taxes. These tax reforms were at least partly due
to the elimination of the budget deficit in 1998 and the projection of increasing sur-
plus in the first decade of the new millennium. But as in the case of the 1987 reforms,
some economists believe that the lower tax rates in the United States also played a
role. An ongoing debate is whether a brain drain to our neighbour to the south is
primarily due to its lower tax rates. It is difficult to assess whether the assertion has
any truth to it because of the difficulty of determining whether those that did leave
did so because of the differential tax burden.
504 Part Four • Microeconomics of Government and Public Policy

The Issue of Freedom

We end our discussion of government decision making by considering a question
that has an elusive answer: What is the relationship between individual freedom
and the size and power of government? We make no attempt here to answer this
question; we merely outline two opposing views.

The Conservative Position

Many conservative economists feel that, in addition to the economic costs of an
expanding public sector, there is also a cost in the form of diminished individual
freedom.
First is the “power corrupts” argument. “Freedom is a rare and delicate plant …
history confirms that the great threat to freedom is the concentration of power … by
concentrating power in political hands, [government] is … a threat to freedom.”2
Second, we can be selective in the market system of the private sector, using our
income to buy precisely what we choose and rejecting unwanted commodities. But,
as noted previously, in the public sector—even assuming a high level of political
democracy—conformity and coercion are inherent. If the majority decides in favour
of certain governmental actions, the minority must conform. The “use of political
channels, while inevitable, tends to strain the social cohesion essential for a stable
society.”3 Because individuals through markets can render decisions selectively, the
need for conformity and coercion is lessened and the “strain” is reduced when deci-
sions are made in the marketplace. The scope of government should be strictly limited.
Finally, centralization of the power and activities of government into bigger gov-
ernment eliminates at least one check on government.

The Liberal Position

Liberal economists are skeptical of the conservative position. They say the conser-
fallacy of vative view is based on the fallacy of limited decisions. That is, conservatives
limited implicitly assume that during any particular period there is a limited, or fixed, num-
decisions ber of decisions to be made in the operation of the economy. If government makes
The false notion
that there are a
more of these decisions in performing its functions, the private sector of the econ-
limited number of omy will necessarily have fewer decisions left to make “freely.” Liberal economists
economic decisions regard this as fallacious reasoning. By sponsoring the production of public goods,
to be made so that, government is extending the range of free choice by permitting society to enjoy
if government goods and services that would not be available without governmental provision.
makes more deci-
sions, there will be
We can argue that it is largely through the economic functions of government that
fewer private deci- we have freed ourselves in some measure from ignorance, unemployment, poverty,
sions to render. disease, crime, discrimination, and other ills. In providing most public goods, gov-
ernment does not typically undertake production itself but, rather, purchases those
goods through private enterprise. When the federal government decides to build an
interprovincial highway, private concerns are given the responsibility of making
many specific decisions and choices in connection with carrying out this decision.
A leading economist has summarized the liberal view in these words:
Traffic lights coerce me and limit my freedom. Yet in the midst of a traffic jam on
the unopen road, was I really “free” before there were lights? And has the alge-

2
Milton Friedman, Capitalism and Freedom (Chicago: University of Chicago Press, 1962), p. 2.
3
Ibid., p. 23.
 chapter nineteen • public choice theory and the economics of taxation 505

braic total of freedom, for me or the representative motorist or the group as a

whole, been increased or decreased by the introduction of well-engineered stop
lights? Stop lights, you know, are also go lights.… When we introduce the traffic
light, we have, although the arch individualist may not like the new order, by
cooperation and coercion created … greater freedom.4

ALMOST EVERYONE WINS WITH

A single rate of tax on Albertan’s
personal incomes would be pro-
gressive, fair, and a benefit to al-
most every taxpayer. Last week,
the Alberta Income Tax Review
Committee recommended pre-
cisely such an idea to the provin-
cial government. Unfortunately,
some politicians and pundits re-
acted with outright hostility as if
the committee suggested club-
bing baby seals instead of low-
ering taxes.
Here is what they recom-
mended: that Albertans stop cal-
culating provincial income tax
as a percentage of federal tax.
Right now, Albertans tally up
their federal taxes and then take
44 percent of that amount (plus
surtaxes) to come up with their
provincial taxes. The report rec-
ommended Albertans calculate
their personal income taxes
based on taxable income—all
deductions and credits will still
be there—and a single tax rate
of 11 percent.
Why should this change
matter? Because the committee
also proposed a provincial basic
A SINGLE RATE OF TAXATION
In an opinion piece in the Calgary Herald, Mark Milke,
director of the Canadian Taxpayers Federation,
extols the merits of the flat tax.
personal exemption of $11,620
(compared to the federal credit
of $6456/$6956—the latter for
low-income earners) and—hold
your breath—indexing it for in-
flation. If successfully imple-
mented, 78,000 low-income Al-
bertans will no longer pay
provincial income tax. And when
indexed for inflation, provincial
taxpayers will be protected
against “bracket creep” taxa-
tion. Hell will first need to freeze
before Ottawa indexes federal
tax brackets for inflation. And as
it will need to snow in Hades be-
fore the federal exemption is
raised to a decent level, it is
worth the change to get the ball
rolling on these two concerns.
So what’s the problem?
Plenty, according to those who
argue the tax system should pe-
nalize productivity and wealth
creation through steeply higher
tax rates according to income.
They may not object to a gener-
ous basic personal exemption,
but they claim a single rate of 11
percent amounts to a flat tax
where the rich would pay the
same rate of tax as the poor. A
single rate, some say, is not
“progressive.”
Nonsense. Because of the
$11,620 exemption, higher in-
comes would still pay a greater
percentage of their total income
in provincial taxes. Earn $10,000
and you pay zero in provincial
income taxes, whereas a $30,000
wage earner would pay 6.7
percent. Earn $60,000 and the
province’s take would be 8.9 per-
cent of your total income. (Don’t
panic if that looks like you would
pay more. None of those figures
include the effect of tax credits.)
Tax rates would still be pro-
gressive but not as harshly steep
as now.
Some claim a single tax rate
would hurt middle income earn-
ers. Poppycock. A revenue neu-
tral change to the tax system
would make some people pay
more if others are to pay less. To
avoid that, the committee had
to propose tax relief for almost
everyone. (OK—a single grocery
clerk making $30,000 a year will
pay an extra 36 bucks if this

4
Paul A. Samuelson, “Personal Freedoms and Economic Freedoms in the Mixed Economy,” in
Earl F. Cheit (ed.), The Business Establishment (New York: John Wiley & Sons, 1964), p. 219.
506 Part Four • Microeconomics of Government and Public Policy

proposal goes through, but he or
she will appreciate the sacrifice.)
As an income group, those
under $30,000 will see 34 per-
cent of the proposed tax reduc-
tion. Those earning over $100,000
will get 29 percent of the cut. The
middle-income crowd will gar-
ner 37 percent of the proposed
tax relief. (Note to critics: that’s
the largest share.) One can jiggle
those figures around to argue
that some middle-income group
will see less of the cut than some
high-income group, but so
what? Regardless, the proposals
will shrink the individual bill for
just about everyone.
This is a problem?
Can Alberta Treasury afford
the $500 million tax cut? Yes.
And they owe it to us. This year,
the province will collect $4.2 bil-
lion in personal income tax in
1998–99. That’s $1 billion more
than three years ago. This year’s
total personal tax take also in-
cludes $350 million from the
high-income surtax and flat tax
imposed in the 1980s to fight a
deficit that disappeared five
years ago. Keep in mind that
part of the boom in personal in-
come tax revenues results from
bracket creep taxation. And need
we address the Canada Pension
Plan increases, which Alberta
agreed to and will take $320 mil-
lion more out of Albertan’s pock-
ets in 1999 than in 1998? On a
personal level, the CPP hikes will
cost a $35,800 salary an extra
$700 a year by 2003 when com-
pared with 1996. Both levels of
government should compensate
Canadians for that tax hike.
Despite this year’s small
provincial tax reduction, taxes
are still historically high in Al-
berta. Fifteen years ago, the
provincial income tax rate was
38.5 percent with no surtaxes on
top. Are critics of tax relief say-
ing Alberta cannot live with tax
rates closer to where they were
during the Lougheed era?
Of course, the province could
cut taxes without changing how
we calculate them. But de-link-
ing provincial taxes from Ottawa
means provincial taxes would no
longer be automatically raised
by federal bracket creep. And a
single rate would preserve pro-
gressivity in the tax system, but
without destroying the incen-
tives to work, save and invest, as
is currently the case under the
steeply progressive and punitive
Ottawa-linked rates.
There is nothing radical about
a single rate of taxation. Five
American states have a single
rate. Another nine have no state
income tax whatsoever. As for
the “flat” tax idea—it does exist
in Hong Kong, where the effec-
tive tax rate is 15 percent and
includes a generous basic per-
sonal exemption and charitable
deductions, which of course,
means it is still progressive.
Most important of all, if Alberta
implements a single rate and
combines it with overall lower
taxes, it will pressure the other
provinces and Ottawa to get
their high tax rates down. That
will promote saving, spending
and investing, which will in turn
have a positive effect upon job
creation.
Source: Calgary Herald Editorials,
November 4, 1998. Reproduced with
the permission of Mark Milke,
Alberta Director for the Canadian
Taxpayers Federation.

chapter summary
1. Majority voting creates a possibility of (a)
an underallocation or an overallocation of
resources to a particular public good and
(b) inconsistent voting outcomes. The median-
voter model predicts that, under majority
rule, the person holding the middle position
on an issue will determine the outcome of an
election involving that issue.
2. Public choice theorists cite reasons why gov-
ernment might be inefficient in providing
public goods and services: (a) There are
strong reasons for politicians to support spe-
cial-interest legislation; (b) Politicians may
be biased in favour of programs with imme-
diate and clear-cut benefits and difficult-to-
identify costs and against programs with
 chapter nineteen • public choice theory and the economics of taxation 507

immediate and easily identified costs and
vague or deferred benefits; (c) Citizens as
voters and governmental representatives
face limited and bundled choices as to pub-
lic goods and services, whereas consumers
in the private sector can be highly selective
in their choices; (d) Government bureaucra-
cies have less incentive to operate efficiently
than do private businesses.
3. The benefits-received principle of taxation
states that those who receive the benefits of
goods and services provided by government
should pay the taxes required to finance
them. The ability-to-pay principle states that
those who have greater income should be
taxed more, absolutely and relatively, than
those who have less income.
4. The federal personal income tax is progres-
sive. The flat rate corporate income tax is
regressive. General sales, excise, and prop-
erty taxes are regressive.
5. Excise taxes affect supply and, therefore,
equilibrium price and quantity. The more
inelastic the demand for a product, the
greater is the portion of an excise tax that is
shifted to consumers. The greater the inelas-
ticity of supply, the larger the portion of the
tax that is borne by the seller.
6. Taxation involves the loss of some output
whose marginal benefit exceeds its marginal
cost. The more elastic the supply and de-
mand curves, the greater the efficiency loss
resulting from a particular tax.
7. Sales taxes normally are shifted to con-
sumers; personal income taxes are not
shifted. Specific excise taxes may or may
not be shifted to consumers, depending on
the elasticities of demand and supply. Dis-
agreement exists as to whether corporate
income taxes are shifted. Property taxes on
owner-occupied property are borne by the
owner; those on rental property are borne
by tenants.
8. The 1987 federal tax reform simplified in-
come taxes and lowered the marginal tax
rate. The 2000 federal tax reform lowered
the personal income tax rate for middle-
income Canadians.
9. The GST is similar to a value added tax. It is
an improvement over the federal sales tax it
replaced because it introduces fewer distor-
tions, exports are exempt, and imports com-
pete on equal footing with domestic goods.
10. Conservatives believe that individual free-
dom shrinks as government grows in size or
power; liberals believe it does not.

terms and concepts

public choice theory, p. 484
logrolling, p. 486
paradox of voting, p. 486
median-voter model, p. 487
government failure, p. 489
special-interest effect, p. 489
rent-seeking behaviour, p. 490
benefits-received principle,
p. 493
ability-to-pay principle, p. 493
progressive tax, p. 494
regressive tax, p. 494
proportional tax, p. 494
tax incidence, p. 496
efficiency loss of a tax, p. 499
Goods and Services Tax
(GST), p. 502
value added tax (VAT), p. 503
fallacy of limited decisions,
p. 504

study questions
1. Explain how affirmative and negative major- three public goods by voters Larry, Curley,
ity votes can sometimes lead to inefficient and Moe:
allocations of resources to public goods. Is
this problem likely to be greater under a
benefits-received or under an ability-to-pay Rankings
tax system? Use the information in Figure
19-1(a) and (b) to show how society might be Public good Larry Curley Moe
better off if Adams were allowed to buy votes.
Courthouse 2nd choice 1st choice 3rd choice
2. KEY QUESTION Explain the paradox
School 3rd choice 2nd choice 1st choice
of voting through reference to the accom-
panying table, which shows the ranking of Park 1st choice 3rd choice 2nd choice
508 Part Four • Microeconomics of Government and Public Policy
3. KEY QUESTION Suppose there are
only five people in a society and each
favours one of the five highway construction
options in Table 18-2 (include no highway
construction as one of the options). Explain
which of these highway options will be
selected using a majority paired-choice vote.
Will this option be the optimal size of the
project from an economic perspective?
4. KEY QUESTION How does the prob-
lem of limited and bundled choice in the
public sector relate to economic efficiency?
Why are public bureaucracies alleged to be
less efficient than private enterprises?
5. Explain: “Politicians would make more ra-
tional economic decisions if they weren’t
running for re-election every few years.”
6. Distinguish between the benefits-received
and the ability-to-pay principles of taxation.
Which philosophy is more evident in our
present tax structure? Justify your answer.
To which principle of taxation do you sub-
scribe? Why?
7. KEY QUESTION Suppose a tax is
such that an individual with an income of
$10,000 pays $2000 of tax, a person with an
income of $20,000 pays $3000 of tax, a per-
son with an income of $30,000 pays $4000 of
tax, and so forth. What is each person’s aver-
age tax rate? Is this tax regressive, propor-
tional, or progressive?
internet application question
1. Some economists contend that public agen-
cies generally are less efficient than private
businesses. Federal Express, <www.fedex.
com>, competes directly with Canada Post,
<www.Canadapost.ca>, for delivery of ex-
press mail and packages. Assume you need
to send an express letter and a package from
8. What is meant by a progressive tax? A re-
gressive tax? A proportional tax? Comment
on the progressivity or regressivity of each of
the following taxes, indicating your assump-
tion concerning tax incidence: (a) the federal
personal income tax, (b) a 7 percent general
sales tax, (c) a federal excise tax on automo-
bile tires, (d) a municipal property tax on real
estate, (e) the federal corporate income tax.
9. KEY QUESTION What is the inci-
dence of an excise tax when demand is
highly inelastic? elastic? What effect does
the elasticity of supply have on the incidence
of an excise tax? What is the efficiency loss
of a tax, and how does it relate to elasticity of
demand and supply?
10. Advanced analysis Suppose the equation for
the demand curve for some product X is P =
8 – .6Q and the supply curve is P = 2 + .4Q.
What are the equilibrium price and quantity?
Now suppose an excise tax is imposed on X
such that the new supply equation is P = 4 +
.4Q. How much tax revenue will this excise
tax yield the government? Graph the curves
and label the area of the graph that repre-
sents the tax collection “TC” and the area
that represents the efficiency loss of the tax
“EL.” Briefly explain why area EL is the effi-
ciency loss of the tax but TC is not.
11. (The Last Word) What are the merits of a sin-
gle rate of taxation? What is the main draw-
back of a single rate of taxation?
your address to either Halifax or Vancouver.
Based on their interactive rate and options
calculators, which service is more competi-
tive as to price and delivery? Does a lower
rate with greater delivery options mean
greater efficiency? Why or why not?
 TWENTY

Canadian
Agriculture:
Economics
and Policy
f you eat, you are part of agriculture! In

IN THIS CHAPTER
Y OU WILL LEARN:
I
Canada, agriculture is economically impor-
tant for several reasons:

● Agriculture accounts for about 1.5 per-

That in the short run
there is significant price and
income instability in the
agricultural sector.
•
The effects of subsidies,
price supports, and price
ceilings in agriculture.
•
About recent agricultural
policy reforms in Canada.
cent of gross domestic product (GDP).
Consumers spend about 10 percent of
their personal consumption expendi-
tures on food.
● Agriculture is an industry that, in the
absence of government farm programs,
is a real-world example of the pure-
competition model (Chapter 9). The in-
dustry consists of many price-taking
firms selling virtually standardized prod-
ucts and can be understood by applying
the supply and demand tools of com-
petitive markets.
510 Part Four • Microeconomics of Government and Public Policy

● Agriculture provides evidence of the intended and unintended effects of gov-

ernment policies that interfere with the forces of supply and demand.
● Farm policies are excellent illustrations of Chapter 19’s special-interest effect
and rent-seeking behaviour.
● Agriculture reflects the increasing globalization of markets. In recent decades
the economic ups and downs of Canadian agriculture have been closely tied to
Canadian access to world markets. Canada’s agricultural exports totalled $21.7
billion in 1999, amounting to 6.6 percent of total Canadian merchandise exports.
These realities justify a full chapter on agriculture. Specifically, we want to examine
the problems in agriculture that have resulted in government intervention, the types
and outcomes of that intervention, and recent major changes in farm policy.

Economics of Agriculture
Over the years, Canadian farmers have faced severely fluctuating prices and peri-
odically low incomes. Agriculture has always been a risky and difficult business.
short- There are actually two separate problems: the short-run farm problem of year-to-
run farm year fluctuations in farm prices and incomes and the long-run farm problem of the
problem The declining agricultural industry.
sharp year-to-year
changes in the
prices of agricul- Short-Run Problem: Price and Income Instability
tural products and
in the incomes of The short-run farm problem is the result of (1) an inelastic demand for agricultural
farmers. products, combined with (2) fluctuations in farm output, and (3) shifts of the
demand curve for farm products.
long-
run farm INELASTIC DEMAND FOR AGRICULTURAL PRODUCTS
problem
The tendency for In industrially advanced economies, the price elasticity of demand for agricultural
agriculture to be a products is low. For farm products in the aggregate, the elasticity coefficient is
declining industry between .20 and .25. These figures suggest that the prices of agricultural products
as technological
progress increases
would have to fall by 40 to 50 percent for consumers to increase their purchases by
supply relative to an a mere 10 percent. Consumers apparently put a low value on additional farm out-
inelastic and slowly put compared with the value they put on additional units of alternative goods.
increasing demand. Why is this so? Recall that the basic determinant of elasticity of demand is sub-
stitutability. When the price of one product falls, the consumer tends to substitute
that product for other products whose prices have not fallen. But in relatively
wealthy societies the substitution effect for food is very modest. Although people
may eat more, they do not switch from three meals a day to, say, five or six meals a
day in response to a decline in the relative prices of farm products. Real biological
factors constrain an individual’s capacity to substitute food for other products.
The inelastic agricultural demand is also related to diminishing marginal utility.
In a high-income economy, the population is generally well fed and well clothed; it
<www.cfa-fca.ca/
index_e.htm>
is relatively saturated with the food and fibre of agriculture. Consequently, addi-
Canadian Federation tional farm products are subject to rapidly diminishing marginal utility. It takes very
of Agriculture large price cuts to induce small increases in food and fibre consumption.

FLUCTUATIONS IN OUTPUT
Farm output tends to fluctuate from year to year, mainly because farmers have lim-
ited control over their output. Floods, droughts, unexpected frost, insect damage,
 chapter twenty • canadian agriculture: economics and policy 511

and similar disasters can mean poor crops, while an excellent growing season
means large crop yields. Such natural phenomena are beyond the control of farm-
ers, yet those phenomena exert an important influence on output.
In addition to natural phenomena, the highly competitive nature of agriculture
makes it difficult for farmers to control production. If the thousands of widely scat-
tered and independent producers happened to plant an unusually large or an
abnormally small portion of their land one year, an extra-large or a very small farm
output would result even if the growing season were normal.
Curve D in Figure 20-1 suggests the inelastic demand for agricultural products.
Combining that inelastic demand with the instability of farm production, we can see
why farm prices and incomes are unstable. Even if the market demand for agriculture
products remains fixed at D, its price inelasticity will magnify small changes in out-
put into relatively large changes in farm prices and income. For example, suppose that
a “normal” crop of Qn results in a “normal” price of Pn and a “normal” farm income
represented by the green rectangle. A very large crop or a poor crop will cause large
deviations from these normal prices and incomes because of the inelastic demand.
If a good growing season occurs, the resulting large crop of Qb will reduce farm
income to that of area 0PbbQb. When demand is inelastic, an increase in the quantity
sold will be accompanied by a more-than-proportionate decline in price. The net
result is that total revenue, that is, total farm income, will decline disproportionately.
Similarly, a poor crop caused by, say, drought will boost total farm income to that
represented by area 0PppQp. A decline in output will cause a more-than-proportionate
increase in price and in income when demand is inelastic. Ironically, for farmers as a
group, a poor crop may be a blessing and a large crop a hardship. With a stable mar-
ket demand for farm products, the inelasticity of that demand will turn relatively
small changes in output into relatively larger changes in farm prices and income.

FLUCTUATIONS IN DEMAND
The third factor in the short-run instability of farm income results from shifts in the
demand curve for agricultural products. Suppose that somehow agricultural output

FIGURE 20-1 THE EFFECT OF OUTPUT CHANGES ON FARM

PRICES AND INCOME
Because of the P
inelasticity of demand
for farm products, a
relatively small Pp p
change in output
(from Qn to Qp or Qb)
will cause a relatively
large change in farm
prices (from Pn to Pb). Pn n
Farm income will
change from the
green area to 0PppQp Normal farm
or 0PbbQb. income
Pb b
D
0 Qp Qn Qb Q
512 Part Four • Microeconomics of Government and Public Policy

FIGURE 20-2 THE EFFECT OF DEMAND SHIFTS ON FARM PRICES

AND INCOME
Because of the highly P
inelastic demand for
agricultural products,
a small shift in
demand (from D1 to
D2) will cause drasti-
cally different levels P1 a
of farm prices (P1 to
P2) and farm income
(area 0P1aQn to area P2
0P2bQn) to be associ- b
ated with a fixed level
of production Qn.
D2 D1
0 Qn Q

is stabilized at the normal level of Qn in Figure 20-2. Now, because of the inelastic-
ity of the demand for farm products, short-run changes in the demand for those
products will cause markedly different prices and incomes to be associated with this
fixed level of output.
A slight drop in demand from D1 to D2 will reduce farm income from area 0P1aQn.
A relatively small decline in demand gives farmers significantly less income for the
same amount of farm output. Conversely, a slight increase in demand—as from D2
to D1—provides a sizable increase in farm income for the same volume of output.
Again, large price and income changes occur because demand is inelastic.
It is tempting to argue that the sharp declines in farm prices that accompany a
decrease in demand will cause many farmers to close down in the short run, reduc-
ing total output and alleviating the price and income declines. But farm production
is relatively insensitive to price changes in the short run because farmers’ fixed costs
are high compared with their variable costs.
Interest, rent, tax, and mortgage payments on land, buildings, and equipment are
the major costs faced by the farmer. These are fixed charges. The labour supply of
farmers and their families can also be regarded as a fixed cost. As long as they stay
on their farms, farmers cannot reduce their costs by firing themselves. Their variable
costs are the costs of the small amounts of extra help they may employ, as well as
expenditures for seed, fertilizer, and fuel. As a result of their high proportion of
fixed costs, farmers are usually better off working their land even when they are los-
ing money, since they would lose much more by shutting down their operations for
the year. Only in the long run will it make sense for them to exit the industry.
Why is agricultural demand unstable? The major source of demand volatility in
Canadian agriculture springs from its dependence on world markets. The incomes
of Canadian farmers are sensitive to changes in weather and crop production in
other countries: better crops abroad mean less foreign demand for Canadian farm
products. Similarly, cyclical fluctuations in incomes in the United States, Europe, or
Southeast Asia, for example, may shift the demand for Canadian farm products.
Changes in foreign economic policies may also change demand. For instance, if the
nations of western Europe decide to provide their farmers with greater protection
 chapter twenty • canadian agriculture: economics and policy 513

from foreign competition, Canadian farmers will have less access to those markets
and demand for Canadian farm exports will fall.
International politics also add to demand instability. Changing political relations
between Canada and the United States and Canada and Russia have boosted
exports to those countries in some periods and reduced them in others. Changes in
the international value of the Canadian dollar may also be critical. Depreciation of
the Canadian dollar increases the demand for Canadian farm products (which
become cheaper for foreign markets), whereas appreciation of the Canadian dollar
diminishes foreign demand for Canadian farm products.
To summarize, the increasing importance of exports has amplified the short-run
instability of the demand for Canadian farm products. Farm exports are affected not
only by weather, income fluctuations, and economic policies abroad but also by inter-
national politics and changes in the international value of the dollar. (Key Question 1)

Long-Run Problem: A Declining Industry

Two other characteristics of agricultural markets explain why agriculture has been
a declining industry (see Table 20-1):
1. Over time, the supply of farm products has increased rapidly because of techno-
logical progress.
2. The demand for farm products has increased slowly, because it is inelastic with
respect to income.
Let’s examine each of these supply and demand forces.

TECHNOLOGY AND SUPPLY INCREASES

TABLE 20-1 THE DECLINING A rapid rate of technological advance has sig-
FARM POPULATION, nificantly increased the supply of agricultural
SELECTED YEARS, products. This technological progress has many
1920–1996 roots: the mechanization of farms, improved
techniques of land management, soil conserva-
Percentage
Farm population, of the total
tion, irrigation, development of hybrid crops,
Year millions population availability of improved fertilizers and insecti-
cides, polymer coated seeds, and improvements
1920 3.18 36.6 in breeding and care of livestock. The amount
1929 3.26 32.2 of capital used per farm worker increased
1933 3.24 30.3 15 times between 1930 and 1980, permitting a
1941 3.15 27.4
fivefold increase in the amount of land culti-
vated per farmer. The simplest measure of
1951 2.91 20.8
these advances is the increasing number of
1961 2.13 11.7 people a single farmer’s output will support.
1971 1.49 6.9 In 1820 each farm worker produced enough
1981 1.08 4.4 food and fibre to support four people; by
1991 0.88* 3.2 1947, that number had risen to about 13. By
1996 0.89* 3.0
2000 each farm produced enough to support
120 people. Unquestionably, the physical vol-
Source: O.J. Firestone, Canada’s Economic Development 1867–1953 ume of farm output per unit of farm labour in
(London: Bowes & Bowes, 1958), p. 60, Statistics Canada,
Census of Canada, 1931–1991, and Statistics Canada, agriculture has risen spectacularly. Over the last
Census of Canada 1996. 50 years, this physical productivity in agricul-
*Estimate based on size of agricultural labour force. ture has advanced twice as fast as in the non-
farm economy.
514 Part Four • Microeconomics of Government and Public Policy

Most of the technological advances in agriculture have not been initiated by farm-
ers, but rather are the result of government-sponsored programs of research and
education and the initiative of farm machinery producers. Experiment stations, edu-
cational pamphlets issued by Agriculture and Agri-Food Canada, and the research
departments of farm machinery, pesticide, and fertilizer producers have been the
primary sources of technological advances in Canadian agriculture.

LAGGING DEMAND
Increases in demand for agricultural products, however, have failed to keep pace
with technologically created increases in the supply of the products. The reason lies
in the two major determinants of agricultural demand: income and population.
Income-Inelastic Demand In developing countries, consumers must devote most of
their meagre incomes to agricultural products—food and clothing—to sustain
themselves. But as income expands beyond subsistence and the problem of hunger
diminishes, consumers increase their outlays on food at ever-declining rates. Once
consumers’ stomachs are filled, they turn to the amenities of life that manufactur-
<www.agr.ca/cb/ ing and services, rather than by agriculture, provide. Economic growth in Canada
factsheets/
2indus_e.html>
has boosted average per capita income far beyond the level of subsistence. As a
Canada’s agrifood result, increases in the incomes of Canadian consumers now produce less-than-
industry factsheet proportionate increases in spending on farm products.
The demand for farm products in Canada is income-inelastic; it is quite insensitive
to increases in income. Estimates indicate that a 10 percent increase in real per capita
after-tax income produces about a 2 percent increase in consumption of farm prod-
ucts. That means a coefficient of income elasticity of .2 (= .02/.10). So, as the incomes
of Canadians rise, the demand for farm products increases far less rapidly than the
demand for products in general.
Population Growth Once a certain income level has been reached, each consumer’s
intake of food and fibre becomes relatively fixed. Thus, subsequent increases in
demand depend directly on growth in the number of consumers. In most advanced
nations, including Canada, the demand for farm products increases at a rate roughly
equal to the rate of population growth. Because Canadian population growth has
not been rapid, however, the increase in Canadian demand for farm products has
not kept pace with the rapid growth of farm output.

GRAPHICAL PORTRAYAL
The combination of an inelastic and slowly increasing demand for agricultural
products with a rapidly increasing supply puts strong downward pressure on farm
prices and income. Figure 20-3 shows a large increase in agricultural supply accom-
panied by a very modest increase in demand. Because of the inelasticity of demand,
those modest shifts result in a sharp decline in farm prices, accompanied by a rela-
tively small increase in output, so farm income declines. On the graph, we see that
farm income before the increases in demand and supply (measured by rectangle
0P1aQ1) exceeds farm income after those increases (0P2bQ2). Because of an inelastic
demand for farm products, an increase in supply of such products relative to
demand creates a persistent downward pressure on farm income.

CONSEQUENCES
The actual consequences over time have been those predicted by the pure-competi-
tion model. Because of the demand and supply conditions just outlined, many
small, high-cost farms that cannot benefit from scale economies or productivity
 chapter twenty • canadian agriculture: economics and policy 515

FIGURE 20-3 A GRAPHICAL DEPICTION OF THE LONG-RUN

CANADIAN FARM PROBLEM
In the long run, P
increases in the demand
for U.S. farm products
S1 S2
(from D1 to D2) have not
kept pace with the
increases in supply
(from S1 to S2) that tech- P1 a
nological advances have
permitted. Because
agricultural demand is
inelastic, these shifts c b
have tended to depress P2
farm prices (from P1 to
P2) and reduce farm
income (from 0P1aQ1 to D2
D1
0P2bQ2) while increasing
output only modestly 0 Q1 Q2 Q
(from Q1 to Q2).

gains cannot operate profitably. In the long run, financial losses in agriculture have
triggered a massive exit of workers to other sectors of the economy, as evidenced by
the declining farm population in Table 20-1. They have also caused a major consol-
idation of smaller farms into larger ones. A person farming, say, 240 hectares of corn
three decades ago is today likely to be farming two or three times that number of
agribusiness acres. Huge corporate firms called agribusiness have emerged in some areas of
Large corporate farming such as potatoes, beef, and poultry.
firms in farming. Traditionally, the income of farm households was far below that of nonfarm
households, but that has changed in the past decade. Outmigration and consolida-
tion have boosted net farm income per farm household, as has the increasing number
of members of farm households who are taking jobs in nearby towns and cities. As
a result, the average income of farm households has increased relative to the income
of nonfarm households. Presently, the average incomes of the two groups are very
similar. (Key Question 3)
As Global Perspective 20.1 shows, poor nations have much higher percentages of
their labour forces in agriculture than do Canada and other industrialized nations.

● Agricultural prices and incomes are volatile in the
short run because an inelastic demand converts
small changes in farm output and demand into
relatively larger changes in prices and income.
● Technological progress has generated large
increases in the supply of farm products over
time.
● Increases in demand for farm products have
been modest in Canada, because demand is
inelastic with respect to income and because
population growth has been modest.
● The combination of large increases in supply
and small increases in demand has made Cana-
dian agriculture a declining industry.
516 Part Four • Microeconomics of Government and Public Policy

20.1

Percentage of Labour Force

Percentage of labour in Agriculture
force in agriculture, 0 25 50 75 100
selected nations
Ethiopia
High-income nations devote a Mozambique
much smaller percentage of their China
labour forces to agriculture than
India
do low-income nations. Because
Brazil
their workforces are so heavily
Russia
committed to producing the food
and fibre needed for their popu- Japan
lations, low-income nations have France
relatively less labour available Canada
to produce housing, schools, United States
autos, and the other goods
Source: International Labour Office, <www.ilo.org/>.
and services that contribute to
a high standard of living.

Economics of Farm Policy

The Canadian government has subsidized agriculture since the 1930s with a farm
program that includes (1) support for farm prices, income, and output; (2) soil and
water conservation; (3) agricultural research; (4) farm credit; (5) crop insurance; and
(6) subsidized sale of farm products in world markets. However, the typical farmer
and the average politician both have viewed the farm program as primarily a pro-
gram to prop up prices and income, and it is this price-support aspect of farm pol-
icy that we will explore. Between 1990 and 1999, Canadian farmers received an
average of over $1 billion of subsidies each year. As indicated in Global Perspective
20.2, farm subsidies are common in many nations.

Rationale for Farm Subsidies

A variety of arguments have been made to justify farm subsidies over the decades:
● Although farm products are necessities of life, many farmers have relatively low
incomes; so they should receive higher prices and incomes through public help.
● The “family farm” is a fundamental Canadian institution and should be nur-
tured as a way of life.
● Farmers are subject to extraordinary hazards—flood, droughts, and insects—
that most other industries do not face. Without government help, farmers can-
not fully insure themselves against these disasters.
● While farmers face purely competitive markets for their outputs, they buy
inputs of fertilizer, farm machinery, and gasoline from industries that have
 chapter twenty • canadian agriculture: economics and policy 517

20.2

Government Subsidies as a
Agricultural subsidies, Percentage of Farm Production, 1999
selected nations
0 20 40 60 80 100
Farmers in various countries Korea
receive large percentages Switzerland
of their incomes as Norway
government subsidies. Japan
European Union
Turkey
United States
Mexico
Canada
Australia
Source: OECD in Figures, pp. 26–27, <www.oecd.org/>, 2000.

considerable market power. Whereas those industries are able to control their
prices, farmers are at the mercy of the market in selling their output. The sup-
porters of subsidies argue that agriculture warrants public aid to offset the dis-
advantageous terms of trade faced by farmers.

The Economics of Price Supports

Canadian agricultural policy in the past has aimed at stabilizing agricultural prices
at levels that result in higher incomes for farmers. The main tools used in agricul-
support tural stabilization are marketing boards and price supports, government-supported
prices Govern- minimum prices.
ment-supported
minimum prices
for agricultural Marketing Boards
products.
Two types of agricultural marketing boards exist. One aims to increase prices by reg-
ulating supply, the other acts as a marketing agency for producers.

HISTORICAL BACKGROUND
During the Great Depression of the 1930s, many farmers believed they were no
match for concentrated agribusiness. The general belief was that the small farmer
faced low offer-to-buy prices from processors, and farmers could not successfully
withhold their produce to force up the price. The political pressure from farmers led
to the passing of the Natural Products Marketing Act in 1934, which set up the Fed-
eral Marketing Board. This board could delegate its power to local producers’
boards, and its most important power was controlling sales of agricultural products.
The federal law was struck down by the courts on the grounds that regulation of
trade within Canada came under provincial jurisdiction. Several provinces, starting
with British Columbia in 1936 and Ontario in 1937, passed laws allowing already func-
tioning marketing boards to continue under provincial authority. By 1940 all provinces
 518 Part Four • Microeconomics of Government and Public Policy

canadian
wheat
marketing
board A board
that maintains the
price of wheat at
board-determined
levels through the
control of product
supply and that
acts as the market-
ing agency for
wheat producers.
<www.cwb.ca>
Canadian Wheat Board
had farm marketing legislation in force except for Quebec, which passed such legisla-
tion in 1956. The main purpose of these marketing boards was supply management: the
maintenance of prices at board-determined levels through control of product supply.
In 1935 the Canadian Wheat Marketing Board was created. As of 2001 it still had
complete control over the price and marketing of western wheat. When farmers
deliver their wheat to the Wheat Board, they receive an initial payment per bushel
that is 75 percent of the expected average selling price. This is in effect a floor price
and is set low enough that the Wheat Board is reasonably able to sell the wheat at
least at that price. The producers subsequently get the full average selling price the
Wheat Board is able to get on the domestic and international markets, less trans-
portation costs, storage costs, and administrative expenses. Farmers get the average
price the Wheat Board is able to realize over the course of the year. A farmer thus does
not have to worry what the price is the day the crop is delivered to the Wheat Board.
Marketing boards aim to stabilize agricultural prices at a level that ensures higher
incomes to farmers. This can be accomplished through price supports.
There are two basic methods of supporting prices above their market equilibrium
values: (1) offers to purchase and (2) deficiency payments.

Offers to Purchase
A marketing board can increase farm income by ensuring that the price farmers get
for their produce does not fall below a specified minimum. In Figure 20-4(a) let’s
assume that the floor price—or, as it is commonly called, the support price—is Ps.
Then the major effects are as follows:
● Surplus output The most obvious result is product surplus. Consumers are
willing to purchase only Qo units at the supported price, while farmers will

FIGURE 20-4 PRICE SUPPORTS AND CROP RESTRICTION

Price Supports

P P P
S S Ss Sr
Surplus
S
Ps a Ps a Pr
c f
Deficiency
payment
Pe b Pe b Pe b
Po d
c
D
S
D D

0 Qo Qe Qs 0 Qe Qs 0 Qr Qe Qf
Quantity Quantity Quantity

(a) Offers to purchase (b) Deficiency payments (c) Crop restriction

Panel (a): Offers to purchase result in surpluses. Panel (b): Deficiency payments or subsidies do not result in surpluses. Panel
(c): Crop restriction results in neither surpluses nor government payments. All costs (the higher price) are borne by consumers.
 chapter twenty • canadian agriculture: economics and policy 519

supply Qs units. The government must buy the surplus (Qs – Qc) to make
the above-equilibrium support price effective. The surpluses are undesirable
on two counts. First, their very existence indicates a misallocation of the
economy’s resources. Government-held surpluses mean that the economy is
devoting too many resources to the production of commodities that, at exist-
ing supported prices, are not wanted by consumers. Second, the storing of
surplus products is expensive, adding to the cost of the farm program
and, ultimately, to the consumer’s tax bill. For example, in the late 1950s the
federal government accumulated more than 45 million kilograms of butter
as it tried to maintain an above-equilibrium price. The solution was to convert
the butter into butter oil, which the government then sold abroad at half the
butter price.
● Loss to consumers Consumers lose because they pay a higher price (Ps rather
than Pe) and consume less (Qo rather than Qe) of the product. They also pay
higher taxes to finance the government’s purchase of the surplus. In Figure
20-4(a), this added tax burden will amount to the surplus output Qo – Qs mul-
tiplied by its price, Ps. Storage costs add to this tax burden. Unfortunately, the
higher food prices fall disproportionately on the poor because they spend a
larger portion of their incomes on food.
● Gain to farmers Farmers gain from price supports. In Figure 20-4(a), gross
receipts rise from the free market level of 0PebQe to the larger supported level
of area 0PsaQs.

Deficiency Payments
deficiency Deficiency payments, another method of price supports, are subsidies that make up
payments the difference between the market price and the government-supported price. In Fig-
Subsidies that make ure 20-4(b) suppose that the support price is Ps. Also, as before, at price Ps farmers
up the difference
between market
expand production from Qe to Qs. However, with demand as shown by D, consumers
prices and govern- will only buy Qs if the price is Po. The government arranges for this to be the market
ment-supported price by simply subsidizing production by the amount Po – Ps. The government
prices. makes a deficiency payment to each producer equal to Po – Ps times the quantity sold.
The total consumer expenditure is 0PocQs, total government expenditure is
PoPsac = deficiency payment times Qs. The producers are still on the original supply
curve S. However, Ss is the supply curve as seen by the consumer and is created by
the deficiency payment. When we analyze the economic effect of these payments,
two considerations arise.

ELASTICITY OF SUPPLY AND DEMAND

The incidence of the subsidy, like the sales tax, depends on the elasticity of the sup-
ply and demand curves. In Figure 20-4(b), the combined effects of the elastic
demand curve in the price range PoPs and the inelastic supply curve result in the
subsidy going mostly to the producer: the producer gets PeSs of the deficiency pay-
ment, the consumer only PePo. The effect of elasticity on the incidence of a subsidy
is precisely the same as that of a sales tax.

COMPARING OFFERS TO PURCHASE AND DEFICIENCY PAYMENTS

Assuming, as we have done, that Ps is the same in both Figures 20-4(a) and (b), farm-
ers will benefit equally from the two programs: their total income will be 0PsaQs in
each case. Consumers prefer deficiency payments since they receive a large amount
520 Part Four • Microeconomics of Government and Public Policy

of output (Qs) at a low price (Po). This compares with a high price (Ps) and small
quantity (Qo) under a program of offers to purchase. But when the subsidies of tax-
payers to farmers (the green areas) are taken into account, we find that total pay-
ments by the public (consumption expenditures plus tax-financed subsidies) to
farmers are identical under both programs: 0PsaQs.
Offers to purchase and deficiency payments have one main difference. Offers to
purchase result in government-held surpluses that can be costly to store. While it
might be desirable to have some reserve stocks as a buffer against a year or two of
crop failures, it is quite another matter for government to spend hundreds of mil-
lions a year simply to store large surpluses of farm commodities.

RESOURCE OVERALLOCATION
A more subtle cost exists in both offers to purchase and deficiency payments. Soci-
ety loses because price supports contribute to economic inefficiency by encouraging
an overallocation of resources to agriculture. A price floor (Ps) attracts more
resources to the agricultural sector than would the free market price (Pe). In terms
of Chapter 9’s pure competition model, the market supply curve in Figure 20-4 rep-
resents the marginal costs of all farmers producing this product at various outputs
Qo. An efficient allocation of resources occurs at point b, where the market price Pe
is equal to marginal costs. The output Qe reflects that efficient allocation of resources.
In contrast, the output Qs associated with the price support Ps represents an over-
allocation of resources; the marginal cost of the extra production exceeds its marginal
benefit to society. Society incurs an efficiency loss from the price-support system.

ENVIRONMENTAL COSTS
We know from Figure 20-4 that price supports lead to additional production.
Although some of this extra output may require additional land, much of the added
production comes from greater use of fertilizer and pesticides. Those pesticides
and fertilizers pollute the environment (for example, groundwater) and pose
health risks to farmworkers and to consumers as residues in food. Research shows
a positive relationship between the level of price-support subsidies and the use
of agrichemicals.
Farm policy may also cause environmental problems in less obvious ways. First,
farmers benefit from price supports only when they use their land consistently for
a specific crop such as corn or wheat. This creates a disincentive to practise crop
rotation, which is a nonchemical technique for controlling pests. Farm policy thus
discourages the substitution of nonchemical for chemical pest control.
Second, an increase in the price of a product will increase the demand for rele-
vant inputs. In particular, price supports for farm products increase the demand for
land. The land that farmers bring into farm production is often environmentally sen-
sitive marginal land such as steeply sloped, highly erodable land or wetlands that
provide wildlife habitat. Similarly, price supports result in the use of more water for
irrigation, and the resulting runoff may contribute to soil erosion.

INTERNATIONAL COSTS
The costs of farm price supports actually go beyond those indicated by Figure 20-4.
Price supports generate economic distortions that cross national boundaries. For
example, price supports make the Canadian agricultural market attractive to foreign
producers. But inflows of foreign agricultural products would increase supplies in
Canada, aggravating the problem of surpluses. To prevent this from happening,
Canada is likely to impose import barriers in the form of tariffs or quotas. These
 chapter twenty • canadian agriculture: economics and policy 521

barriers often restrict the output of more efficient foreign producers, while simulta-
neously encouraging more output from less efficient Canadian producers. The
result is a less efficient use of world agricultural resources.
Similarly, as Canada and other industrially advanced countries with similar agri-
cultural programs dump surplus farm products on world markets, the prices of
such products are depressed. Developing countries—heavily dependent on world
commodity markets for their incomes—are hurt because their export earnings are
reduced. Thus, Canadian price supports for wheat production have imposed sig-
nificant costs on Argentina, a major wheat exporter. (Key Question 7)

Reduction of Surpluses
Figure 20-4 suggests that programs designed to reduce market supply (shift S left-
ward) or increase market demand (shift D rightward) would help boost the market
price toward the supported price Ps. Further, such programs would reduce or elim-
inate farm surpluses. The Canadian government has tried both supply and demand
approaches to reduce or eliminate surpluses.

RESTRICTING SUPPLY
Until recently, public policy focused mainly on restricting farm output. In particu-
crop lar, crop restriction accompanied price supports. In return for guaranteed prices for
restriction their crops, farmers had to agree to limit the number of hectares they planted in that
In return for crop. The government first set the price support and then estimated the amount of
guaranteed prices
for their crops,
the product consumers would buy at the supported price. It then translated that
farmers agree to amount into the total number of planted hectares necessary to provide it.
limit the number of These supply-restricting programs were only partially successful. They did not
hectares they plant eliminate surpluses, mainly because reduction of land under cultivation did not
in that crop. result in a proportionate decline in production. Some farmers retired their worst
land and kept their best land in production. They also cultivated their tilled land
more intensively. Superior seed, more and better fertilizer and insecticides, and
improved farm equipment were used to enhance output per hectare. Nevertheless,
the net effect of crop restriction undoubtedly was to reduce farm surpluses and their
associated costs to taxpayers.

BOLSTERING DEMAND
Government has tried several ways to increase demand for Canadian agricultural
products.
New Uses Both government and private industry have spent large sums on
research to create new uses for agricultural goods. The production of “gasohol,”
which is a blend of gasoline and alcohol made from grain, is one such attempt to
increase the demand for farm output. A less significant example is the use of soy-
beans to replace wax in producing crayons. Most experts conclude that such endeav-
ours have been only modestly successful in bolstering the demand for farm products.
Domestic and Foreign Demand The government has also created a variety of pro-
grams to stimulate domestic consumption of farm products. For example, the fed-
eral government spends millions of dollars each year to advertise and promote
global sales of Canadian farm products. Furthermore, Canadian negotiators have
pressed hard in international trade negotiations to persuade foreign nations to
reduce trade barriers to the importing of farm products. The government’s supply-
restricting and demand-increasing efforts have helped reduce the amount of surplus
production, but they have not succeeded in eliminating surpluses.
522 Part Four • Microeconomics of Government and Public Policy

● Marketing boards aim to stabilize agricultural
prices at levels that ensure higher incomes to
farmers.
● Price supports are government-imposed price
floors (minimum prices) on selected farm prod-
ucts. Price supports can be achieved through
(1) offers to purchase, (2) deficiency payments,
or (3) crop restrictions.
● Price supports cause surplus production; raise
farm income; increase food prices to consumers;
and cause an overallocation of resources to
agriculture.
● Domestic price supports encourage nations to
erect trade barriers against imported farm prod-
ucts and to dump surplus farm products on
world markets.

Criticism, Politics, and Reform

After 60 years of experience with government price-support programs, it became
apparent that those programs were not working well. There was a growing feeling
among economists and political leaders that the goals and techniques of farm pol-
icy needed to be re-examined and revised.
<www.agr.ca/
index_e.phtml> Criticisms
Agriculture and
Agri-Food Canada Let’s examine some of the key criticisms of the agricultural subsidies.

SYMPTOMS, NOT CAUSES

The subsidy strategy in agriculture was designed to treat the symptoms, not the
causes, of the farm problem. The root cause of the problem was a misallocation of
resources between agriculture and the rest of the economy. Historically, the problem
has been one of too many farmers. The effect of that misallocation has been rela-
tively low farm income. For the most part, public policy was oriented toward sup-
porting farm prices and incomes rather than toward fixing the resource allocation
problem itself.
Further, price and income supports have served to keep people in agriculture
who otherwise would have moved to nonfarm occupations. That is, the price and
income orientation of the farm program has slowed the reallocation of resources
necessary to resolve the long-run farm problem.

MISGUIDED SUBSIDIES
Price supports and subsidy programs have traditionally benefited those farmers
most who need them least. If the goal of farm policy is to raise low farm incomes, it
follows that any program of federal aid should be aimed at farmers with the lowest
incomes. But the poor, low-output farmer does not produce and sell enough in the
market to get much aid from price supports. Instead, the large corporate farm reaps
the benefits by virtue of its sizable output.
Furthermore, an income-support program might better be geared to people than
to products. Most economists say that, on equity grounds, direct income subsidies
to struggling farmers are highly preferable to indirect price-support subsidies that
go primarily to large, prosperous farmers. Better yet, say some economists, would
be transition and retraining support for farmers willing to move out of farming into
occupations and businesses in greater demand.
 chapter twenty • canadian agriculture: economics and policy 523

A related point concerns land values. The price and income benefits that farm
programs provide tend to increase the value of farmland. By making crops more
valuable, price supports make the land itself more valuable. Sometimes that ten-
dency is helpful to farmers, but often it is not. Farmers rent about 50 percent of their
farmland, mostly from well-to-do nonfarm landlords. Thus, price supports become
a subsidy to people who are not actively engaged in farming.

POLICY CONTRADICTIONS
Because farm policy has many objectives, it often leads to contradictions. Whereas
most subsidized research is aimed at increasing farm productivity and the supply of
farm products, crop restriction programs require that farmers take land out of pro-
duction to reduce supply. Price supports for crops mean increased feed costs for
ranchers and high consumer prices for animal products. Tobacco farmers are subsi-
dized at a time when serious health problems are associated with tobacco con-
sumption. Conservation programs call for setting aside land for wildlife habitat,
while price supports provide incentives to bring such land into production.

The Politics of Farm Policy

In view of these criticisms and inconsistencies, we might ask why Canada contin-
ued its price-support program for major crops for so many decades and still con-
tinues it for some farm products such as sugar, peanuts, and tobacco today. Why
did it take so long for the government to restore free markets for at least some
farm products?

PUBLIC CHOICE THEORY REVISITED

Public choice theory (Chapter 19) helps us answer these questions. Recall that rent-
seeking behaviour occurs when a group (a labour union, firms in a specific indus-
try, or farmers producing a particular crop) uses political means to transfer income
or wealth to itself at the expense of another group or of society as a whole. And
recall that the special-interest effect involves a program or policy from which a small
group receives large benefits at the expense of a much larger group whose members
individually suffer small losses. Both rent-seeking behaviour and the special-inter-
est effect help explain the politics of farm subsidies.
Suppose a certain group of farmers, say, egg producers or dairy farmers, organ-
ize and establish a well-financed political action committee (PAC). The PAC’s job is
to promote government programs that will transfer income to the group (this is rent-
seeking behaviour). The PAC vigourously lobbies members of Parliament to enact
or to continue price supports and import quotas for eggs and milk. The PAC does
this in part by making political contributions to sympathetic legislators. Although
egg production is heavily concentrated in a few provinces, the egg PAC will also
make contributions to legislators from other provinces to gain support.
How can a small interest group like egg or milk producers successfully lobby to
increase its own income at the expense of society as a whole? Because, even though
the total cost of the group’s programs might be considerable, the cost imposed on
each individual taxpayer is small (this is the special-interest effect). Taxpayers are
likely to be uninformed about and indifferent to such programs, since they have lit-
tle at stake. Unless you raise your own chickens to provide your family’s egg supply,
you probably have no idea how much these programs cost you as an individual tax-
payer and consumer and therefore do not object when your member of Parliament
524 Part Four • Microeconomics of Government and Public Policy

votes for, say, a price support program for eggs. Thus, there is little or no lobbying to
counter the PAC’s efforts.
Public choice theory also tells us that politicians are likely to favour programs
that have hidden costs. As we have seen, that is often true of farm programs. Our
discussion of Figure 20-4 indicated that price supports involve not simply a trans-
fer of money from taxpayer to farmer but costs that are hidden as higher food prices,
storage costs for surplus output, costs of administering farm programs, and costs
associated with both domestic and international misallocations of resources.
Because those costs are largely indirect and hidden, farm programs are much more
acceptable to politicians and the public than they would be if all costs were explicit.

CHANGING POLITICS
In spite of rent seeking, special interests, and logrolling, a combination of factors has
led to a change in the politics of farm subsidies.
Declining Political Support As the farm population has declined, agriculture’s
political power has weakened. The farm population was about 30 percent of the
general population in the 1930s, when many Canadian farm programs were estab-
lished; now it is less than 3 percent. Urban members of Parliament now constitute
a majority over their rural colleagues. An increasing number of them are critically
examining farm programs for their effect on consumers’ grocery bills as well as on
farm incomes. Also, more farmers themselves are coming to resent the intrusion of
the federal government into their farming decisions.
World Trade Considerations Canada is one of the countries that has taken the lead
to reduce barriers to world trade in agricultural products. That has also contributed
to the more critical attitude toward farm subsidies and particularly price supports.
The nations of the European Union (EU) and many other nations provide support
for agricultural prices. And, to maintain their high domestic prices, they restrict
imports of foreign farm products by imposing tariffs (excise taxes) and quotas
(quantitative limits on imports of foreign goods). They then try to rid themselves of
their domestic surpluses by subsidizing exports into world markets.
The effects on Canada are that (1) trade barriers hinder Canadian farmers from
selling to EU nations, and (2) subsidized exports from those nations depress world
prices for agricultural products, making world markets less attractive to Canadian
farmers.
Perhaps most important, farm programs such as those maintained by the EU and
Canada distort both world agricultural trade and the international allocation of
agricultural resources. Encouraged by artificially high prices, farmers in industrially
advanced nations produce more food and fibre than they would otherwise. The
resulting surpluses flow into world markets, where they depress prices. This means
that farmers in countries with no farm programs—many of them developing coun-
tries—face artificially low prices for their exports, and that signals them to produce
less. Overall, the result is a shift in production away from what would occur based
on comparative advantage.
Recognizing these distortions, in 1994 the world’s trading nations agreed to
reduce farm price-support programs by 20 percent by the year 2000 and to reduce
tariffs and quotas on imported farm products by 15 percent. Canada made such a
strong case against price supports in these discussions that its stance undoubtedly
helped alter the domestic debate on whether supports should be continued within
this country.
 chapter twenty • canadian agriculture: economics and policy 525

● Farm policy in Canada has been heavily criti-
cized for delaying the shift of resources away
from farming, directing most subsidies to
wealthier farmers, and being fraught with pol-
icy contradictions.
● The persistence of price supports can largely be
explained in terms of rent-seeking behaviour,
the special-interest effect, political logrolling,
and other aspects of public choice theory.
● Recently, the politics of farm subsidies has
changed as a result of the declining politi-
cal power of farmers and world trade con-
siderations.

ALL ABOUT CANADA’S

The Canadian egg industry was
valued at $995 million in 1999, al-
most $30 million of which were
exports; this figure includes
hatching eggs, eggs for con-
sumption, and processed eggs.
About 22 million Canadian laying
hens produce close to six billion
eggs, with the average laying
hen producing about 272 eggs
per year.
Canada ranks as the 24th egg-
producing country in the world,
responsible for 0.7 percent of
world egg production in 1998.
The largest producer is China,
followed by the United States,
Japan, the Russian Federation,
India, Mexico, and Brazil.
Eight-two percent of Cana-
dian eggs are sold in their shells,
and the remaining 18 percent
of all grades and sizes are
processed into liquid, frozen, or
dried form. Quebec and Ontario
produce more than half the eggs
in Canada. Ontario alone con-
EGG INDUSTRY
The egg industry in Canada has evolved during
the past 100 years from backyard flocks and
erratic marketing to a highly specialized,
automated, and highly regulated industry.
tributes 39.8 percent of the total, ers. The Canadian Egg Marketing
Quebec produces 16.6 percent, Agency (CEMA) is the producer
the Western provinces have a organization responsible for
combined egg production of supply management in Canada.
35.6 percent, and the Eastern They ensure that producers re-
provinces have a combined pro- ceive their cost of production
duction of 8.0 percent. plus a reasonable rate of return
Research at universities and on their investment while con-
colleges, by provincial and fed- sumers have a constant supply
eral governments, and in private at stable prices.
industry is under way in Canada Because of changing dietary
to investigate ways to improve habits, annual total egg con-
the egg and poultry industries, in- sumption in Canada dropped
cluding disease control and erad- from 23 dozen per person in 1960
ication, feed management, genet- to 14.3 dozen in 1995. However,
ics, automation, and new product in the past few years, consump-
development. Poultry production tion has increased again, and in
and processing are among the 1998, egg consumption was 15.2
most highly mechanized sectors dozen per person. Processed egg
in Canadian agriculture. consumption has increased dra-
Getting the egg from the pro- matically since 1986.
ducer to the grocery store re-
quires coordination and cooper- Source: Agriculture and Agri-Food
ation among producers, egg Canada, Factsheet, <www.agr.ca/cb/
graders, processors, provincial factsheets/2egg_e.html>, 2001; and
Snapshot of the Canadian Egg
and federal governments, in- Industry, <www.agr.ca/misb/aisd/
spectors, distributors, and retail- poultry/eggsnap.pdf>, 1999.
526 Part Four • Microeconomics of Government and Public Policy
chapter summary
1. In the short run, the highly inelastic nature of
agricultural demand translates small changes
in output and small shifts in domestic or for-
eign demand into large changes in prices and
income.
2. Over the long run, rapid technological ad-
vance, together with a highly inelastic and rel-
atively slow-growing demand for agricultural
output, has caused agriculture to be a declin-
ing industry.
3. The use of price floors or price supports has
many economic effects: (a) surplus production
occurs, (b) the incomes of farmers are in-
creased, (c) consumers pay higher prices for
farm products, (d) an overallocation of re-
sources to agriculture occurs, (e) society pays
higher taxes to finance the purchase and stor-
age of surplus output, (f) pollution increases
because of the greater use of agrichemicals
and vulnerable land, and (g) other nations bear
the costs associated with import barriers and
depressed world agricultural prices.
4. Government has pursued with limited suc-
cess programs to limit agricultural supply and
terms and concepts
short-run farm problem, agribusiness, p. 515
p. 510 support prices, p. 517
long-run farm problem, Canadian Wheat Marketing
p. 510 Board, p. 518
study questions
1. KEY QUESTION Carefully evaluate:
“The supply and demand for agricultural
products are such that small changes in agri-
cultural supply result in drastic changes in
prices. However, large changes in farm prices
have modest effects on agricultural output.”
(Hint: A brief review of the distinction between
supply and quantity supplied may be helpful.)
Do exports increase or reduce the instability
of demand for farm products? Explain.
2. What relationship, if any, can you detect
between the fact that the farmer’s fixed costs
of production are large and the fact that the
supply of most agricultural products is gen-
erally inelastic? Be specific in your answer.
increase agricultural demand to reduce the
surpluses associated with price supports.
5. Economists have criticized farm policy for
(a) confusing symptoms (low farm incomes)
with causes (excess capacity), (b) providing
the largest subsidies to high-income farmers,
and (c) creating contradictions among spe-
cific farm programs.
6. The persistence of agricultural subsidies can
be explained in terms of public choice theory
and, in particular, in terms of rent-seeking
behaviour and the special-interest effect.
7. Political backing for price supports and crop
restriction programs has eroded for several
reasons: (a) The number of farmers, and thus
their political clout, has declined dramatically
relative to the number of urban consumers
of farm products, (b) farm subsidies have
received close scrutiny due to efforts to elim-
inate the federal budget deficit, (c) successful
efforts by Canada to get other nations to
reduce their farm subsidies have altered the
domestic debate on the desirability of Cana-
dian farm subsidies.
deficiency payments,
p. 519
crop restriction, p. 521
3. KEY QUESTION Explain how each of
the following contributes to the farm problem:
a. the inelastic demand for farm products
b. the rapid technological progress in farming
c. the modest long-run growth in demand
for farm commodities
d. the volatility of export demand
4. The key to efficient resource allocation is
shifting resources from low-productivity to
high-productivity uses. In view of the high
and expanding physical productivity of agri-
cultural resources, explain why many econ-
omists want to divert additional resources
from farming to achieve allocative efficiency.
 chapter twenty • canadian agriculture: economics and policy
5. Explain and evaluate: “Industry complains of
the higher taxes it must pay to finance sub-
sidies to agriculture. Yet the trend of agri-
cultural prices has been downward while
industrial prices have been moving upward,
suggesting that on balance agriculture is
actually subsidizing industry.”
6. “Because consumers as a whole must ulti-
mately pay the total incomes received by
farmers, it makes no real difference whether
the income is paid through free farm mar-
kets or through price supports supple-
mented by subsidies financed out of tax
revenue.” Do you agree?
7. KEY QUESTION Explain the eco-
nomic effects of price supports. Explicitly
include environmental and global impacts in
your answer. On what grounds do econo-
mists contend that price supports cause a
misallocation of resources?
8. Use supply and demand curves to depict
equilibrium price and output in a competi-
tive market for some farm product. Then
show how an above-equilibrium price floor
(price support) would cause a surplus in this
market. Demonstrate in your graph how gov-
ernment could reduce the surplus through a
policy that (a) changes supply or (b) changes
demand. Identify each of the following
actual government policies as primarily
internet application question
1. Agriculture and Agri-Food Canada at
<www.agr.ca/cb/factsheets/2indus_e.html>
provides an overview of Canadian agricul-
ture and the agrifood business. What are
527
affecting the supply of or the demand for
a particular farm product: crop restriction,
government buyout of dairy herds, export
promotion.
9. Do you agree with each of the following
statements? Explain why or why not.
a. “The problem with Canadian agriculture
is that there are too many farmers. This is
not the fault of farmers but the fault of
government programs.”
b. “The federal government ought to buy
Canadian farm surpluses and give them
away to developing nations.”
c. “All industries would like government
price supports if they could get them;
agriculture received price supports only
because of its strong political clout.”
10. What are the effects of farm subsidies such
as those of Canada and the European Union
on (a) domestic agricultural prices, (b) world
agricultural prices, and (c) the international
allocation of agricultural resources?
11. Use public choice theory to explain the per-
sistence of farm subsidies in the face of
major criticisms of these subsidies.
12. (The Last Word) How many eggs does the
average Canadian laying hen produce? Which
country is the largest producer of eggs?
Canada’s top five agricultural exports?
Which country imports the largest share of
Canada’s agricultural exports?
Glossary
A information about a product
ABILITY-TO-PAY PRINCIPLE The
idea that those who have greater
income (or wealth) should pay a
greater proportion of it as taxes
than those who have less income
(or wealth).
ABSOLUTE ADVANTAGE When a
given amount of resources can
produce more of a commodity in
one country than in another.
ABSOLUTE POVERTY A situation in
which the basic material needs of
an individual or a family (food,
clothing, shelter) are not met.
ADVERSE SELECTION PROBLEM A
problem arising when informa-
tion known to one party to a con-
tract is not known to the other
party, causing the latter to incur
major costs.
AGGREGATE A collection of spe-
cific economic units treated as if
they were one unit.
AGRIBUSINESS Large corporate
firms in farming.
ALLOCATIVE EFFICIENCY The appor-
tionment of resources among
firms and industries to obtain the
production of the products most
wanted by society (consumers);
the output of each product at
which its marginal cost and price
or marginal benefit are equal.
ANTI-COMBINES (ANTIMONOPOLY)
LEGISLATION Laws designed to
prevent the growth of monopoly.
ANTI-COMBINES POLICY The laws
and government actions designed
to prevent monopoly and pro-
mote competition.
APPRECIATION (OF THE DOLLAR) An
increase in the value of the dollar
relative to the currency of another
nation so that a dollar buys a
larger amount of the foreign cur-
rency and thus of foreign goods.
ASYMMETRIC INFORMATION A situ-
ation in which one party to a mar-
ket transaction has much more
or service than the other does;
the result may be an under-
allocation or overallocation of
resources.
AVERAGE FIXED COST (AFC) A firm’s
total fixed cost divided by
output (the quantity of product
produced).
AVERAGE PRODUCT (AP) The total
output produced per unit of a
resource employed (total product
divided by the quantity of that
employed resource).
AVERAGE REVENUE Total revenue
from the sale of a product divided
by the quantity of the product
sold.
AVERAGE TOTAL COST (ATC) A firm’s
total cost divided by output (the
quantity of product produced);
equal to average fixed cost plus
average variable cost.
AVERAGE VARIABLE COST (AVC) A
firm’s total variable cost divided
by output (the quantity of product
produced).
B determined levels through the
BARRIERS TO ENTRY Anything that
artificially prevents the entry of
firms into an industry.
BARTER The exchange of one
good or service for another good
or service.
BENEFITS-RECEIVED PRINCIPLE The
idea that those who receive the
benefits of goods and services
provided by government should
pay the taxes required to finance
them.
BILATERAL MONOPOLY A market in
which there is a single seller
(monopoly) and a single buyer
(monopsony).
BLACK MARKETS Markets in which
products are illegally bought and
sold at prices above the legal
limits.
BONDS Financial devices through
which a borrower (a firm or gov-
ernment) is obligated to pay the
principle and interest on a loan at
a specific date in the future.
BREAK-EVEN POINT An output at
which a firm makes a normal
profit but not an economic profit.
BUDGET CONSTRAINT The limit that
the size of a consumer’s income
(and the prices that must be paid
for goods and services) imposes
on the ability of that consumer to
obtain goods and services.
BUDGET LINE A line that shows
the different combinations of
two products a consumer can
purchase with a specific money
income, given the products’
prices.
C
CANADA PENSION PLAN (CPP) A
national retirement plan funded
by obligatory employer and
employee contributions.
CANADIAN WHEAT MARKETING
BOARD A board that maintains
the price of wheat at board-
control of product supply and that
acts as the marketing agency for
wheat producers.
CAPITAL Human-made resources
(buildings, machinery, and equip-
ment) used to produce goods and
services; goods that do not
directly satisfy human wants; also
called capital goods.
CARTEL A formal agreement
among firms in an industry to set
the price of a product and estab-
lish the outputs of the individual
firms or to divide the market
among them.
CHANGE IN DEMAND A change in
the quantity demanded of a good
or service at every price; a shift
of the demand curve to the left
or right.

CHANGE IN QUANTITY DEMANDED
A movement from one point to
another on a fixed demand curve
caused by a change in price of the
product under consideration.
CHANGE IN QUANTITY SUPPLIED
A movement from one point
to another on a fixed supply
curve caused by a change in
the price of a product under
consideration.
CHANGE IN SUPPLY A change in
the quantity supplied of a good
or service at every price; a shift
of the supply curve to the left or
right.
CIRCULAR FLOW MODEL The flow
of resources from households to
firms and of products from firms
to households. These flows are
accompanied by reverse flows of
money from firms to households
and from households to firms.
COASE THEOREM The idea first
stated by economist Ronald
Coase that spillover problems
may be resolved through private
negotiations of the affected
parties.
COLLUSION A situation in which
firms act together and in agree-
ment to fix prices, divide a
market, or otherwise restrict
competition.
COMBINES INVESTIGATION ACT The
Act, in 1910, that authorized a
judge, on receiving an application
by six people, to order an investi-
gation into an alleged combine;
became the Competition Act in
1986.
COMMAND SYSTEM An economic
system in which property
resources are owned by the
government and the economic
decisions are made by a central
government body.
COMPARATIVE ADVANTAGE A lower
relative or comparative cost than
another producer.
COMPENSATING DIFFERENCES
Differences in the wages received
by workers in different jobs to
compensate for nonmonetary
differences in the jobs.
COMPETITION ACT The Act that
replaced the Combines Investiga-
tion Act in 1986.
COMPETITION TRIBUNAL A govern-
ment body that adjudicates under
a civil law framework that will
permit the issuing of remedial
orders to restore and maintain
competition in the market.
COMPETITION The presence in a
market of a large number of inde-
pendent buyers and sellers com-
peting with one another and the
freedom of buyers and sellers to
enter and leave the market.
COMPLEMENTARY GOODS Products
and services that are used
together; when the price of one
falls the demand for the other
increases (and conversely).
CONCENTRATION RATIO The per-
centage of the total sales of an
industry produced and sold by
an industry’s largest firms.
CONGLOMERATE MERGER The
merger of a firm in one industry
with a firm in another industry or
region.
CONSTANT RETURNS TO SCALE The
range of output between the out-
put at which economies of scale
end and diseconomies of scale
begin.
CONSTANT-COST INDUSTRY An
industry in which the entry of
new firms has no effect on
resource prices and thus no
effect on production costs.
CONSUMER GOODS Products and
services that satisfy human wants
directly.
CONSUMER SOVEREIGNTY Deter-
mination by consumers of the
types and quantities of goods
and services that will be pro-
duced with the scarce resources
of the economy; consumer direc-
tion of production through their
dollar votes.
CONSUMER SURPLUS The differ-
ence between what a consumer
is willing to pay for an additional
unit of a product or service and
its market price.
glossary 529
CORPORATION A legal entity char-
tered by the federal government
that operates as a distinct and
separate body from the individu-
als who own it.
COST–BENEFIT ANALYSIS Compar-
ing the marginal costs of a gov-
ernment project or program with
the marginal benefits to decide
whether to employ resources in
that project or program and to
what extent.
CREATIVE DESTRUCTION The
hypothesis that the creation of
new products and production
methods simultaneously destroys
the market power of existing
monopolies.
CROP RESTRICTION In return for
guaranteed prices for their crops,
farmers agree to limit the number
of hectares they plant in that
crop.
CROSS ELASTICITY OF DEMAND The
ratio of the percentage change in
quantity demanded of one good
to the percentage change in the
price of some other good; a posi-
tive coefficient indicates the two
products are substitute goods; a
negative coefficient indicates they
are complementary goods.
D
DEADWEIGHT LOSS The loss of
consumer surplus and producer
surplus when output is either
below or above its efficient level.
DECREASING-COST INDUSTRY An
industry in which the entry of
firms lowers the prices of
resources and thus decreases
production costs.
DEFICIENCY PAYMENTS Subsidies
that make up the difference
between market prices and
government-supported prices;
a method of price support.
DEMAND CURVE A curve that illus-
trates demand.
DEMAND SCHEDULE A schedule
showing the amounts of a good
or service buyers (or a buyer)
wish to purchase at various prices
during some period.
530 glossary
DEPENDENT VARIABLE A variable
that changes as a consequence of
a change in some other (inde-
pendent) variable; the “effect”
or outcome.
DEPRECIATION (OF THE DOLLAR)
A decrease in the value of
the dollar relative to another
currency so that a dollar buys a
smaller amount of the foreign
currency and therefore of foreign
goods.
DERIVED DEMAND The demand
for a resource that depends on
the products it can be used to
produce.
DETERMINANTS OF DEMAND Factors
other than its price that determine
the quantities demanded of a
good or service.
DETERMINANTS OF SUPPLY Factors
other than its price that determine
the quantities supplied of a good
or service.
DIFFERENTIATED OLIGOPOLY An oli-
gopoly in which the firms pro-
duce a differentiated product.
DIFFUSION The widespread imita-
tion of an innovation.
DIRECT RELATIONSHIP The relation-
ship between two variables that
change in the same direction, for
example, product price and quan-
tity supplied.
DISCRIMINATION COEFFICIENT A
measure of the cost or disutility
of prejudice; the monetary
amount an employer is willing to
pay to hire a preferred worker
rather than a nonpreferred
worker.
DISECONOMIES OF SCALE Increase
in the average total cost of pro-
ducing a product as the firm
expands the size of its plant (its
output) in the long run.
DIVISION OF LABOUR Dividing the
work required to produce a prod-
uct into a number of different
tasks that are performed by
different workers; specialization
of workers.
DOLLAR VOTES The “votes” that
consumers and entrepreneurs
cast for the production of con-
sumer and capital goods, respec-
tively, when they purchase them
in product and resource markets.
DOUBLE TAXATION The taxation
of both corporate net income
(profits) and the dividends paid
from this net income when they
become the personal income of
households.
E set of institutional arrangements
ECONOMIC (OPPORTUNITY) COST A
payment that must be made to
obtain and retain the services of a
resource; the income a firm must
provide to a resource supplier to
attract the resource away from
an alternative use; equal to the
quantity of other products that
cannot be produced when
resources are instead used to
make a particular product.
ECONOMIC (PURE) PROFIT The total
revenue of a firm less its eco-
nomic costs (which includes both
explicit costs and implicit costs);
also called above normal profit.
ECONOMIC GROWTH (1) An out-
ward shift in the production pos-
sibilities curve that results from
an increase in resource supplies
or quality or an improvement in
technology; (2) an increase either
in real output (gross domestic
product) or in real output per
capita.
ECONOMIC PERSPECTIVE A view-
point that envisions individuals
and institutions making rational
decisions by comparing the
marginal benefits and marginal
costs associated with their
actions.
ECONOMIC PROBLEMS Choices
are necessary because society’s
material wants for goods and
services are unlimited but the
resources available to satisfy
these wants are limited (scarce).
ECONOMIC PROFIT The total rev-
enue of a firm less its economic
costs (which includes both
explicit costs and implicit costs);
also called “pure profit” and
“above normal profit.”
ECONOMIC RENT The price paid for
the use of land and other natural
resources, the supply of which is
fixed (perfectly inelastic).
ECONOMIC RESOURCES The land,
labour, capital, and entrepreneur-
ial ability that are used in the pro-
duction of goods and services;
productive agents; factors of
production.
ECONOMIC SYSTEM A particular
and a coordinating mechanism
for solving the economizing prob-
lem; a method of organizing an
economy; of which the market
economy, command economy,
and traditional economy are
three general types.
ECONOMICS The social science
dealing with the use of scarce
resources to obtain the maximum
satisfaction of society’s virtually
unlimited economic wants.
ECONOMIES OF SCALE Reductions
in the average total cost of pro-
ducing a product as the firm
expands the size of plant (its
output) in the long run; the
economies of mass production.
EFFICIENCY LOSS OF A TAX The loss
of net benefits to society because
a tax reduces the production and
consumption of a taxed good
below the level of allocative
efficiency.
ELASTIC DEMAND Product or
resource demand whose price
elasticity is greater than one;
means the resulting change in
quantity demanded is greater
than the percentage change in
price.
ELASTICITY OF RESOURCE DEMAND
The percentage change in
resource quantity divided by the
percentage change in resource
price; if the result is greater than
one, resource demand is elastic;
if the result is less than one,
resource demand is inelastic;
and when the result equals one,
resource demand is unit-elastic.
EMPLOYMENT DISCRIMINATION
Inferior treatment in hiring, pro-

motion, and work assignment for
a particular group of employees.
EMPLOYMENT EQUITY Policies
and programs that establish tar-
gets of increased employment
and promotion for women and
minorities.
EMPLOYMENT INSURANCE (EI) A
program that insures workers
against the hazards of losing
their jobs.
ENTREPRENEURIAL ABILITY The
human resources that combine
the other resources to produce a
product, make non-routine deci-
sions, innovate, and bear risks.
EQUILIBRIUM POSITION The combi-
nation of products that yields the
greatest satisfaction or utility; the
combination will lie on the high-
est attainable indifference curve.
EQUILIBRIUM PRICE The price in
a competitive market at which
the quantity demanded and the
quantity supplied are equal,
where there is neither a shortage
nor a surplus, and where there
is no tendency for price to rise
or fall.
EQUILIBRIUM QUANTITY The quan-
tity demanded and supplied at
the equilibrium price in a compet-
itive market.
EURO The common currency unit
used by 12 European nations in
the Euro zone, which includes all
nations of the European Union
except Great Britain, Denmark,
and Sweden.
EUROPEAN UNION (EU) An associa-
tion of 15 European nations that
has eliminated tariffs and import
quotas among them, established
common tariffs for goods
imported from outside the
member nations, allowed the free
movement of labour and capital
among them, and created other
common economic policies;
includes Austria, Belgium,
Denmark, Finland, France,
Germany, Great Britain, Greece,
Ireland, Italy, Luxembourg, the
Netherlands, Portugal, Spain,
and Sweden.
EXCESS CAPACITY Plant or equip-
ment that is underused because
the firm is producing less than
the minimum-ATC output.
EXCHANGE RATE The rate of
exchange of one nation’s
currency for another nation’s
currency.
EXCLUSION PRINCIPLE The ability
to exclude those who do not pay
for a product from receiving its
benefits.
EXCLUSIVE UNIONISM The practice
of a labour union of restricting
the supply of skilled union
labour to increase the wages
received by union members; the
policies typically employed by a
craft union.
EXPECTED-RATE-OF-RETURN CURVE
The increase in profit a firm anti-
cipates it will obtain by investing
in R&D.
EXPLICIT COSTS The monetary
payments a firm must make to an
outsider to obtain a resource.
EXPORT SUBSIDIES Government
payments to domestic producers
to enable them to reduce the
price of a good or service to for-
eign buyers.
EXTERNALITIES A benefit or cost
from production or consumption
accruing without compensation
to nonbuyers and nonsellers of
the product.
F FREE-RIDER PROBLEM The inability
FACTORS OF PRODUCTION Economic
resources: land, capital, labour,
and entrepreneurial ability.
FAIR-RETURN PRICE The price of a
product that enables its producer
to obtain a normal profit and that
is equal to the average cost of
producing it.
FALLACY OF COMPOSITION Incor-
rectly reasoning that what is true
for the individual (or part) is
necessarily true for the group
(or whole).
FALLACY OF LIMITED DECISIONS The
false notion that there are a lim-
ited number of economic deci-
glossary 531
sions to be made so that, if gov-
ernment makes more decisions,
there will be fewer private deci-
sions to render.
FAST-SECOND STRATEGY The strat-
egy of becoming the second firm
to embrace an innovation, allow-
ing the originator to incur the ini-
tial high costs of innovation.
FIRM An organization that
employs resources to produce a
good or service for profit and that
owns and operates one or more
plants.
FIXED COSTS Any cost that in total
does not change when the firm
changes its output; the cost of
fixed resources.
FOREIGN EXCHANGE MARKET A mar-
ket in which the money (currency)
of one nation can be used to pur-
chase (can be exchanged for) the
money of another nation.
FREEDOM OF CHOICE The freedom
of owners of property resources
to employ or dispose of them as
they see fit, of workers to enter
any line of work for which they
are qualified, and of consumers
to spend their incomes in a man-
ner that they think is appropriate.
FREEDOM OF ENTERPRISE The free-
dom of firms to obtain economic
resources, to use these resources
to produce products of the firm’s
own choosing, and to sell their
products in markets of their
choice.
of potential providers of an eco-
nomically desirable but indivisi-
ble good or service to obtain
payment from those who benefit,
because the exclusion principle
is not applicable.
FULL EMPLOYMENT (1) Use of all
available resources to produce
want-satisfying goods and serv-
ices. (2) The situation when the
unemployment rate is equal to
the full-employment unemploy-
ment rate and there is frictional
and structural but no cyclical
unemployment (and the real out-
put of the economy equals its
potential real output).
532 glossary
FULL PRODUCTION Employment of
available resources so that the
maximum amount of (or total
value of) goods and services is
produced; occurs when both pro-
ductive efficiency and allocative
efficiency are realized.
G squared percentage market share
GAME THEORY MODEL A means of
analyzing the pricing behaviour of
oligopolists using the theory of
strategy associated with games
such as chess and bridge.
GENERAL AGREEMENT ON TARIFFS
AND TRADE (GATT) The interna-
tional agreement reached in 1947
in which 23 nations agreed to
give equal and nondiscriminatory
treatment to the other nations, to
reduce tariff rates by multina-
tional negotiations, and to elimi-
nate import quotas. Now includes
most nations and has become the
World Trade Organization.
GENERALIZATIONS Statements of
the nature of the relation between
two or more sets of facts.
GOODS AND SERVICES TAX (GST)
Federal tax that replaced the
federal sales tax in Canada; it is
7 percent on a broad base of
goods and services (the only
exemptions are agricultural
and fish products, prescription
drugs, and medical devices);
businesses remit the difference
between the value of their sales
and the value of its purchases
from other firms.
GOVERNMENT FAILURE Inefficien-
cies in resource allocation
caused by problems in the oper-
ation of the public sector (gov-
ernment); occurs because of
rent-seeking pressure by special-
interest groups, short-sighted
political behaviour, limited and
bundled choices, and bureau-
cratic inefficiencies.
GUARANTEED INCOME SUPPLEMENT
(GIS) Money paid on application,
subject to a means test, to those
receiving an OAS pension who
have an income below a certain
level.
GUIDING FUNCTION OF PRICES The
ability of price changes to bring
about changes in the quantities
of products and resources
demanded and supplied.
H value) of a good that may be
HERFINDAHL INDEX The sum of the
of all firms in the industry.
HOMOGENEOUS OLIGOPOLY An oli-
gopoly in which the firms pro-
duce a standardized product.
HORIZONTAL AXIS The “left–right”
or “west–east” axis on a graph
or grid.
HORIZONTAL MERGER A merger
between two competitors selling
similar products in the same
market.
HOUSEHOLD An economic unit
(of one or more persons) that
provides the economy with
resources and uses the income
received to purchase goods and
services that satisfy material
wants.
HUMAN CAPITAL DISCRIMINATION
Arbitrary restriction of particular
groups from productivity-
enhancing investments in
education and training.
I INCOME ELASTICITY OF DEMAND
ILLEGAL IMMIGRANTS People who
enter a country unlawfully and
live there.
IMITATION PROBLEM A firm’s rivals
may be able to imitate the new
product or process, greatly reduc-
ing the originator’s profit from its
R&D effort.
IMPERFECT COMPETITION The
market models pure monopoly,
monopolistic competition, and
oligopoly considered as a group.
IMPLICIT COSTS The monetary
income a firm sacrifices when it
uses a resource it owns rather
than supplying the resource in
the market; equal to what the
resource could have earned in the
best-paying alternative employ-
ment; includes a normal profit.
IMPORT COMPETITION The compe-
tition domestic firms encounter
from the products and services of
foreign producers.
IMPORT QUOTA A limit imposed by
a nation on the quantity (or total
imported during some period.
INCENTIVE FUNCTION OF PRICE The
inducement that an increase in
the price of a commodity gives
to sellers to make more of it
available (and conversely for a
decrease in price), and the
inducement that an increase
in price offers to buyers to
purchase smaller quantities
(and conversely for a decrease
in price).
INCENTIVE PAY PLAN A compensa-
tion structure that ties worker
pay directly to performance such
as piece rates, bonuses, stock
options, commissions, and profit
sharing.
INCLUSIVE UNIONISM The practice
of a labour union of including as
members all workers employed
in an industry.
INCOME EFFECT A change in the
quantity demanded of a product
that results from the change in
real income (purchasing power)
produced by a change in the
product’s price.
The ratio of the percentage
change in the quantity demanded
of a good to a percentage change
in consumer income; measures
the responsiveness of consumer
purchases to income changes.
INCOME INEQUALITY The unequal
distribution of an economy’s total
income among households or
families.
INCOME MOBILITY The movement
of individuals and families from
one income quintile to another
over time.
INCREASING-COST INDUSTRY An
industry in which the entry of
new firms raises the prices for
resources and thus increases
their production costs.

INDEPENDENT VARIABLE The vari-
able causing a change in some
other (dependent) variable.
INDIFFERENCE CURVES Curves
showing the different combina-
tions of two products that yield
the same satisfaction or utility to
a consumer.
INDIFFERENCE MAP A series of
indifference curves, each of which
represents a different level of util-
ity and together show the prefer-
ences of a consumer.
INDUSTRY A group of firms that
produce the same or similar
products.
INELASTIC DEMAND Product or
resource demand for which the
price elasticity coefficient is less
than one; means the resulting
percentage change in quantity
demanded is less than the per-
centage change in price.
INFERIOR GOOD A good or service
whose consumption declines as
income rises (and conversely),
price remaining constant.
INNOVATION The first successful
commercial introduction of a new
product, the first use of a new
method of production, or the cre-
ation of a new form of business
organization.
INSURABLE RISK An event that
would result in a loss but whose
frequency of occurrence can be
estimated with considerable accu-
racy; insurance companies are
willing to sell insurance against
such losses.
INTEREST-RATE COST-OF-FUNDS
CURVE A graph showing the inter-
est rate a firm must pay to obtain
funds to finance R&D.
INTERINDUSTRY COMPETITION
The competition between the
products of one industry and
the products of another
industry.
INVENTION The discovery of a
product or process using imagi-
nation, ingenious thinking, and
experimentation and the first
proof that it will work.
INVERSE RELATIONSHIP The rela-
tionship between two variables
that change in opposite direc-
tions, for example, product price
and quantity demanded.
INVERTED-U THEORY A theory
saying that, other things being
equal, R&D expenditures as a
percentage of sales rise with
industry concentration, reach a
peak at a four-firm concentration
ratio of about 50 percent, and
then fall as concentration further
increases.
INVESTMENT IN HUMAN CAPITAL
Any expenditure undertaken to
improve the education, skills,
health, or mobility of workers,
with an expectation of greater
productivity and thus a positive
return on the investment.
INVESTMENT Spending for the
production and accumulation
of capital and additions to
inventories.
INVISIBLE HAND The tendency
of firms and resource suppliers
seeking to further their own self-
interests in competitive markets
to also promote the interest of
society as a whole.
K LEGAL CARTEL THEORY OF REGULATION
KINKED-DEMAND CURVE The
demand curve for a noncollusive
oligopolist that is based on the
assumption that rivals will follow
a price decrease and will not
follow a price increase.
L LIMITED LIABILITY Restriction of
LABOUR The physical and mental
talents and efforts of people that
are used to produce goods and
services.
LAND Natural resources (“free
gifts of nature”) used to produce
goods and services.
LAW OF CONSERVATION OF MATTER
AND ENERGY Matter can be trans-
formed into other matter or into
energy but never vanish.
LAW OF DEMAND The principle
that, other things equal, an
glossary 533
increase in a product’s price
will reduce the quantity of it
demanded; and conversely for
a decrease in price.
LAW OF DIMINISHING MARGINAL
UTILITY As a consumer increases
the consumption of a good or
service, the marginal utility
obtained from each additional
unit of the good or service
decreases.
LAW OF DIMINISHING RETURNS As
successive increments of a vari-
able resource are added to a fixed
resource, the marginal product
of the variable resource will
eventually decrease.
LAW OF INCREASING OPPORTUNITY
COSTS As the production of a
good increases, the opportunity
cost of producing an additional
unit rises.
LAW OF SUPPLY The principle that,
other things equal, an increase
in the price of a product will
increase the quantity of it sup-
plied; and conversely for a price
decrease.
LEAST-COST COMBINATION OF
RESOURCES The quantity of each
resource a firm must employ to
produce a particular output at the
lowest total cost.
The hypothesis that some indus-
tries seek regulation or want to
maintain regulation so that they
may form a legal cartel.
LEGAL IMMIGRANTS People who
lawfully enter a country and live
there.
the maximum loss to a predeter-
mined amount for the owners
(stockholders) of a corporation,
the maximum loss is the amount
they paid for their shares of stock.
LOANABLE FUNDS THEORY OF
INTEREST The concept that the
supply of and demand for
loanable funds determine the
equilibrium rate of interest.
LOGROLLING The trading of
votes by legislators to secure
favourable outcomes on decisions
534 glossary
concerning the provision of pub-
lic goods and quasipublic goods.
LONG RUN A period of time long
enough to enable producers of a
product to change the quantities
of all the resources they employ;
period in which all resources
and costs are variable and no
resources or costs are fixed.
LONG-RUN FARM PROBLEM The
tendency for agriculture to be a
declining industry as technologi-
cal progress increases supply rel-
ative to an inelastic and slowly
increasing demand.
LONG-RUN SUPPLY CURVE A curve
that shows the prices at which a
purely competitive industry will
make various quantities of the
product available in the long run.
LORENZ CURVE A curve showing
the distribution of income in an
economy; the cumulated percent-
age of families (income receivers)
is measured along the horizontal
axis and cumulated percentage of
income is measured along the
vertical axis
M product.
MACROECONOMICS The part of
economics concerned with the
economy as a whole; with such
major aggregates as the house-
hold, business, and governmental
sectors; and with measures of the
total economy.
MARGINAL ANALYSIS The compari-
son or marginal (“extra” or “addi-
tional”) benefits and marginal
costs, usually for decision making.
MARGINAL COST (MC) The extra
(additional) cost of producing one
more unit of output; equal to the
change in total cost divided by
the change in output (and in the
short run to the change in total
variable cost divided by the
change in output).
MARGINAL PRODUCT (MP) The extra
output produced with one addi-
tional unit of a resource.
MARGINAL PRODUCTIVITY THEORY OF
INCOME DISTRIBUTION The con-
tention that the distribution of
income is fair when each unit of
each resource receives a money
payment equal to its marginal
contribution to the firm’s revenue
(its marginal revenue product).
MARGINAL RATE OF SUBSTITUTION
The rate at which a consumer is
prepared to substitute one good
for another (from a given combi-
nation of goods) and remain
equally satisfied (have the same
total utility); equal to the slope of
a consumer’s indifference curve
at each point on the curve.
MARGINAL RESOURCE COST (MRC)
The amount that each additional
unit of resource adds to the firm’s
total (resource) cost.
MARGINAL REVENUE PRODUCT (MRP)
The change in total revenue from
employing one additional unit of
a resource.
MARGINAL REVENUE PRODUCTIVITY
How much workers contribute to
their employers’ revenue; usually
reflected in their pay level.
MARGINAL REVENUE The change
in total revenue that results from
selling one more unit of a firm’s
MARGINAL UTILITY The extra
utility a consumer obtains from
the consumption of one addi-
tional unit of a good or service;
equal to the change in total utility
divided by the change in the
quantity consumed.
MARKET FOR EXTERNALITY RIGHTS
A market in which firms can buy
rights to discharge pollutants; the
price of such rights is determined
by the demand for the right and a
perfectly inelastic supply of such
rights (the latter is determined by
the quantity of discharges that
the environment can assimilate).
MARKET PERIOD A period in which
producers of a product are unable
to change the quantity produced
in response to a change in its
price; in which there is a perfectly
inelastic supply.
MARKET SYSTEM All the product
and resource markets of a market
economy and the relationships
among them; a method that
allows the prices determined
in these markets to allocate the
economy’s scarce resources and
to communicate and coordinate
the decisions made by consumers,
firms, and resource suppliers.
MARKET Any institution or
mechanism that brings together
buyers (demanders) and sellers
(suppliers) of a particular good
or service.
MC = MB RULE For a government
project, marginal benefit should
equal marginal cost to produce
maximum benefit to society.
MEDIAN-VOTER MODEL The theory
that under majority rule the
median (middle) voter will be in
the dominant position to deter-
mine the outcome of an election.
MEDIUM OF EXCHANGE Items sell-
ers generally accept and buyers
generally use to pay for a good
or service; money; a convenient
means of exchanging goods and
services without engaging in
barter.
MICROECONOMICS The part of
economics concerned with such
individual units as industries,
firms, and households; and with
individual markets, particular
prices, and specific goods and
services.
MINIMUM EFFICIENT SCALE (MES)
The lowest level of output at
which a firm can minimize long-
run average costs.
MINIMUM WAGE The lowest wage
employers may legally pay for an
hour of work.
MONEY Any item that is generally
acceptable to sellers in exchange
for goods and services.
MONOPOLISTIC COMPETITION A
market structure in which many
firms sell a differentiated product
and entry into and exit from the
market is relatively easy.
MONOPSONY A market structure
in which there is only a single
buyer of a good, service, or
resource.

MORAL HAZARD PROBLEM The
possibility that individuals or
institutions will change their
behaviour as the result of a
contract or agreement.
MOST-FAVOURED-NATION (MFN)
CLAUSE An agreement by Canada
to allow some other nation’s
exports into Canada at the lowest
tariff level levied by Canada, then
or later.
MR = MC RULE A method of deter-
mining the total output at which
economic profit is at a maximum
(or losses at a minimum).
MRP = MRC RULE To maximize eco-
nomic profit (or minimize losses)
a firm should use the quantity of
a resource at which its marginal
revenue product is equal to its
marginal resource cost.
MULTINATIONAL CORPORATION
A firm that owns production
facilities in other countries and
produces and sells its product
abroad.
MUTUAL INTERDEPENDENCE A situ-
ation in which a change in strat-
egy (usually price) by one firm
will affect the sales and profits
of other firms.
N forgone or sacrificed to produce
NATURAL MONOPOLY An industry
in which economies of scale are
so extensive that a single firm
can supply the entire market at a
lower unit cost than could a
number of competing firms.
NATURAL MONOPOLY An industry
in which economies of scale are
so great that a single firm can
produce the product at a lower
average total cost than if more
than one firm produced the
product.
NETWORK EFFECTS Increases in the
value of a product to each user,
including existing ones, as the
total number of users rises.
NOMINAL INTEREST RATE The
interest rate expressed in terms
of annual amounts currently
charged for interest and not
adjusted for inflation.
NOMINAL WAGE The amount of
money received by a worker per
unit of time (hour, day, etc.).
NONCASH TRANSFER Government
transfer payments in the form of
goods and services rather than
money; for example, food
stamps, housing assistance, and
job training; also called in-kind
transfers.
NONCOMPETING GROUPS Collec-
tions of workers in the economy
who do not compete with each
other for employment because
the skill and training of the work-
ers in one group are substantially
different from those in other
groups.
NONPRICE COMPETITION A selling
strategy in which one firm tries to
distinguish its product or service
from all competing ones based
on attributes other than price and
then advertising the distinguished
product to consumers.
NON-TARIFF BARRIERS All barriers
other than protective tariffs that
nations erect to impede interna-
tional trade, including import
quotas, licensing requirements,
unreasonable product-quality
standards, unnecessary red
tape in customs procedures,
and so on.
NORMAL GOOD A good or service
whose consumption increases
when income increases and falls
when income decreases, price
remaining constant.
NORMAL PROFIT The payment
made by a firm to obtain and
retain entrepreneurial ability; the
minimum income entrepreneurial
ability must receive to induce it to
perform entrepreneurial functions
for a firm.
NORMATIVE ECONOMICS The part
of economics involving value
judgments about what the econ-
omy should be like; concerned
with which economic goals and
policies should be implemented.
NORTH AMERICAN FREE TRADE
AGREEMENT (NAFTA) A 1993 agree-
ment establishing, over a 15-year
period, a free trade zone com-
glossary 535
posed of Canada, Mexico, and
the United States.
O
OCCUPATIONAL DISCRIMINATION
Arbitrary restriction of particular
groups from more desirable,
higher-paying occupations.
OCCUPATIONAL LICENSING The
laws of provincial or municipal
governments that require a
worker to satisfy certain specified
requirements and obtain a
licence from a licensing board
before engaging in a particular
occupation.
OCCUPATIONAL SEGREGATION
Crowding women or minorities
into less desirable, lower-paying
occupations.
OLD AGE SECURITY (OAS) A pension
paid on application at age 65 to
everyone resident in Canada for
at least 10 years immediately
before turning 65.
OLIGOPOLY A market structure in
which a few large firms produce
homogeneous or differentiated
products.
OPPORTUNITY COST The amount
of other products that must be
a unit of a product.
OPTIMAL AMOUNT OF R&D The
amount of funding for which the
expected rate of return and the
interest cost of borrowing are
equal.
OPTIMAL REDUCTION OF AN EXTER-
NALITY The point at which soci-
ety’s marginal cost and marginal
benefit of reducing that external-
ity are equal.
OTHER-THINGS-EQUAL ASSUMPTION
The assumption that factors other
than those being considered are
held constant.
OUTPUT EFFECT An increase in the
price of one input will increase
a firm’s production costs and
reduce its level of output, thus
reducing the demand for other
inputs (and vice versa).
536 glossary
P POST HOC, ERGO PROPTER HOC
PARADOX OF VOTING A situation
in which paired-choice voting by
majority rule fails to provide a
consistent ranking of society’s
preferences for public goods or
services.
PARTNERSHIP An unincorporated
firm owned and operated by two
or more people.
PATENT An exclusive right to
sell any new and useful process,
machine, or product for a set time.
PERFECTLY ELASTIC DEMAND Prod-
uct or resource demand in which
quantity demanded can be of any
amount at a particular product
price; graphs as a horizontal
demand curve.
PERFECTLY ELASTIC SUPPLY Product
or resource supply in which
quantity supplied can be of any
amount at a particular product
or resource price; graphs as a
horizontal supply curve.
PERFECTLY INELASTIC DEMAND
Product or resource demand in
which price can be of any amount
at a particular quantity of the prod-
uct or resource demanded; quan-
tity demanded does not respond
to a change in price; graphs as a
vertical demand curve.
PERFECTLY INELASTIC SUPPLY Prod-
uct or resource supply in which
price can be of any amount at a
particular quantity of the product
or resource demanded; quantity
supplied does not respond to a
change in price; graphs as a verti-
cal supply curve.
PLANT A physical establishment
that performs one or more func-
tions in the production, fabrica-
tion, and distribution of goods
and services.
POLICY ECONOMICS The formula-
tion of courses of action to bring
about desired economic out-
comes or to prevent undesired
occurrences.
POSITIVE ECONOMICS The analysis
of facts or data to establish
scientific generalizations about
economic behaviour.
FALLACY Incorrectly reasoning
that when one event precedes
another the first event must have
caused the second event.
PRICE CEILING A legally estab-
lished maximum price for a good
or service.
PRICE DISCRIMINATION The selling
of a product to different buyers
at different prices when the price
differences are not justified by
differences in cost.
PRICE ELASTICITY OF DEMAND The
ratio of the percentage change in
quantity demanded of a product
or resource to the percentage
change in its price; a measure of
the responsiveness of buyers to a
change in the price of a product
or resource.
PRICE ELASTICITY OF SUPPLY The
ratio of the percentage change
in quantity supplied of a product
or resource to the percentage
change in its price; the respon-
siveness of producers to a
change in the price of a product
or resource.
PRICE FLOORS Legally determined
prices above the equilibrium
price.
PRICE LEADERSHIP An implicit
understanding oligopolists use
to coordinate prices without
engaging in outright collusion by
having the dominant firm initiate
price changes and all other firms
follow.
PRICE WAR Successive and con-
tinuous rounds of price cuts by
rivals as they attempt to maintain
their market shares.
PRICE-TAKER A firm in a purely
competitive market that cannot
change market price but only
adjust to it.
PRINCIPAL–AGENT PROBLEM A con-
flict of interest that occurs when
agents (workers or managers)
pursue their own objectives to the
detriment of the principal’s (stock-
holders) goals.
PRINCIPALS Statements about
economic behaviour that enable
prediction of the probable effect
of certain actions.
PRIVATE PROPERTY The right of pri-
vate persons and firms to obtain,
own, control, employ, dispose of,
and bequeath land, capital, and
other property.
PROCESS INNOVATION The devel-
opment and use of new or
improved production or distribu-
tion methods.
PRODUCER SURPLUS The difference
between what producers receive
for a product or service and the
marginal cost of producing it.
PRODUCT DIFFERENTIATION A strat-
egy in which one firm’s product
is distinguished from competing
products by means of its design,
related services, quality, location,
or other attributes (except price).
PRODUCT INNOVATION The devel-
opment and sale of a new or
improved product or service.
PRODUCT MARKET A market in
which products are sold by firms
and bought by households.
PRODUCTION POSSIBILITIES CURVE
A curve that shows the different
combinations of two goods or
services that can be produced in a
full-employment, full-production
economy where the available
supplies of resources and tech-
nology are fixed.
PRODUCTION POSSIBILITIES TABLE A
table showing the different com-
binations of two products that
can be used produced with a
specific set of resources in a
full-employment, full-production
economy.
PRODUCTIVE EFFICIENCY The pro-
duction of a good in the least
costly way; occurs when produc-
tion takes place at the output at
which average total cost is a
minimum and at which marginal
product per dollar’s worth of
input is the same for all inputs.
PROFIT-MAXIMIZING COMBINATION
OF RESOURCES The quantity of
each resource a firm must
employ to maximize its profits
or minimize its losses.

PROGRESSIVE TAX A tax whose
average tax rate increases as the
taxpayer’s income increases and
decreases as the taxpayer’s
income decreases.
PROPORTIONAL TAX A tax whose
average tax rate remains constant
as the taxpayer’s income
increases or decreases.
PROTECTIVE TARIFF A tariff
designed to shield domestic
producers of a good or service
from the competition of foreign
producers.
PUBLIC CHOICE THEORY The eco-
nomic analysis of collective and
government decision making,
politics, and the democratic
process.
PUBLIC GOOD A good or service
that is indivisible and to which
the exclusion principle does not
apply; a good or service with
these characteristics provided
by government.
PUBLIC INTEREST THEORY OF REGULA-
TION The theory that industrial
regulation is necessary to keep a
natural monopoly from charging
monopoly prices and thus harm-
ing consumers and society.
PURE COMPETITION A market struc-
ture in which a very large number
of firms produce a standardized
product.
PURE MONOPOLY A market struc-
ture in which one firm is the sole
seller of a product or service.
PURE RATE OF INTEREST An essen-
tially risk-free, long-term interest
rate not influenced by market
imperfections.
PURELY COMPETITIVE LABOUR
MARKET A resource market in
which a large number of (noncol-
luding) firms demand a particular
type of labour supplied by a large
number of nonunion workers.
Q against other groups.
QUASI-PUBLIC GOOD A good or
service to which the exclusion
principle could apply, but that has
such a large spillover benefit that
government sponsors its produc-
tion to prevent an underallocation
of resources.
R lection of data, and the formula-
RATIONAL BEHAVIOUR Human
behaviour based on comparison
of marginal costs and marginal
benefits; behaviour designed to
maximize total utility.
RATIONING FUNCTION OF PRICES
The ability of market forces in a
competitive market to equalize
quantity demanded and quantity
supplied and to eliminate short-
ages and surpluses via changes
in prices.
REAL INTEREST RATE The interest
rate expressed in dollars of
constant value (adjusted for
inflation); equal to the nominal
interest rate less the expected
rate of inflation.
REAL WAGE The amount of goods
and services a worker can pur-
chase with a nominal wage; the
purchasing power of the nominal
wage.
REGRESSIVE TAX A tax whose aver-
age tax rate decreases as the tax-
payer’s income increases and
decreases as the taxpayer’s
income decreases.
RELATIVE POVERTY A situation in
which an individual’s or a family’s
income is low relative to others
in society.
RENT-SEEKING BEHAVIOUR The
actions by persons, firms, or
unions to gain special benefits
from government at taxpayers’
or someone else’s expense.
RESOURCE MARKET A market in
which households sell and firms
buy resources or the services of
resources.
REVERSE DISCRIMINATION The view
that the preferential treatment
associated with employment
equity constitutes discrimination
ROUNDABOUT PRODUCTION The
construction and use of capital to
aid in the production of consumer
goods.
glossary 537
S
SCIENTIFIC METHOD The system-
atic pursuit of knowledge through
the formulation of a problem, col-
tion and testing of hypotheses.
SELF-INTEREST That which each
firm, property owner, worker, and
consumer believes is best for
itself and seeks to obtain.
SHORT RUN A period of time in
which producers are able to
change the quantities of some
but not all of the resources they
employ; a period in which some
resources (usually plant) are fixed
and some are variable.
SHORTAGE The amount by which
the quantity demanded of a prod-
uct exceeds the quantity supplied
at a particular (below-equilibrium)
price.
SHORT-RUN FARM PROBLEM The
sharp year-to-year changes in the
prices of agricultural products
and in the incomes of farmers.
SHORT-RUN SUPPLY CURVE A curve
that shows the quantities of the
product a firm in a purely com-
petitive industry will offer to sell
at various prices in the short run.
SIMULTANEOUS CONSUMPTION A
product’s ability to satisfy a large
number of consumers at the
same time.
SINGLE-TAX MOVEMENT A move-
ment spearheaded by Henry
George in the late nineteenth
century to make taxes on rental
income the only tax levied by
government; few advocates
remain.
SLOPE OF A LINE The ratio of the
vertical change (the rise or fall)
to the horizontal change (the run)
between any two points on a line.
The slope of an upward sloping
line is positive, reflecting a direct
relationship between two vari-
ables; the slope of a downward
sloping line is negative, reflecting
an inverse relationship between
two variables.
SOCIAL REGULATION Government
regulation of the conditions under
538 glossary
which goods are produced, the
physical characteristics of goods,
and the impact of the production
on society.
SOCIALLY OPTIMAL PRICE The price
of a product that results in the
most efficient allocation of an
economy’s resources.
SOLE PROPRIETORSHIP An unincor-
porated firm owned and operated
by one person.
SPECIAL-INTEREST EFFECT Any
result of government promotion
of the interests (goals) of a small
group at the expense of a much
larger group.
SPECIALIZATION The use of the
resources of an individual, a firm,
a region, or a nation to produce
one or a few goods and services.
SPILLOVER BENEFIT A benefit
obtained without compensation
by third parties from the produc-
tion or consumption of sellers or
buyers. Example: A beekeeper
benefits when a neighbouring
farmer plants clover.
SPILLOVER COSTS A cost imposed
without compensation on third
parties by the production or con-
sumption of sellers or buyers.
Example: A manufacturer dumps
toxic chemicals into a river, killing
the fish sought by sport fishers.
START-UPS Small new companies
that focus on creating and
introducing a new product or
employing a new production
or distribution technique.
STATIC ECONOMY An economy
in which resource supplies,
technological knowledge, and
consumer tastes are constant
and unchanging.
STATISTICAL DISCRIMINATION
Judging individuals on the
average characteristic of the
group to which they belong
rather than on their own personal
characteristics.
STOCKS (CORPORATE) Ownership
shares in a corporation.
SUBSTITUTE GOODS Products or
services that can be used in place
of each other. When the price of
one falls the demand for the other
falls, and conversely with an
increase of price.
SUBSTITUTION EFFECT (1) A change
in the quantity demanded of a
consumer good that results from
a change in its relative expensive-
ness produced by a change in the
product’s price. (2) The effect of a
change in the price of a resource
on the quantity of the resource
employed by a firm, assuming no
change in its output.
SUPPLY CURVE A curve that illus-
trates supply.
SUPPLY SCHEDULE A schedule
showing the amounts of a good
or service sellers (or a seller) will
offer at various prices during
some period.
SUPPORT PRICES Government-
supported minimum prices for
agricultural products.
SURPLUS The amount by which
the quantity supplied of a product
exceeds the quantity demanded
at a specific (above-equilibrium)
price.
T TRADE BLOC A group of nations
TACIT UNDERSTANDINGS Any
method by competing oligopo-
lists to set prices and outputs
that does not involve outright
collusion.
TASTE-FOR-DISCRIMINATION MODEL
A theory of discrimination that
views it as a preference for which
an employer is willing to pay.
TAX INCIDENCE The person or
group who ends up paying a tax.
TECHNOLOGICAL ADVANCE New
and better goods and services
and new and better ways of pro-
ducing or distributing them.
TERMS OF TRADE The rate at which
units of one product can be
exchanged for units of another
product; the price of a good or
service; the amount of one good
or service that must be given up
to obtain one unit of another
good or service.
THEORETICAL ECONOMICS The
process of deriving and applying
economic theories and principals.
TOTAL COST The sum of fixed cost
and variable cost.
TOTAL PRODUCT (TP) The total out-
put of a particular good or service
produced by a firm (or a group of
firms or the entire economy).
TOTAL REVENUE The total number
of dollars received by a firm (or
firms) from the sale of a product;
equal to the total expenditures for
the product produced by the firm
(or firms); equal to the quantity
sold (demanded) multiplied by
the price at which it is sold.
TOTAL UTILITY The total amount
of satisfaction derived from the
consumption of a single product
or a combination of products.
TOTAL-REVENUE TEST A test to
determine elasticity of demand
between any two prices: Demand
is elastic if total revenue moves
in the opposite direction as
price; it is inelastic when it moves
in the same direction as price;
and it is of unitary elasticity when
it does not change when price
changes.
that lower or abolish trade barri-
ers among members. Examples
include the European Union and
the nations of the North American
Free Trade Agreement.
TRADEOFF BETWEEN EQUALITY AND
EFFICIENCY The decrease in
economic efficiency that may
accompany a decrease in income
inequality; the presumption
that some income inequality is
required to achieve economic
efficiency.
TRADEOFFS The sacrifice of
some or all of one economic goal,
good, or service to achieve some
other goal, good, or service.
TRAGEDY OF THE COMMONS Air,
water, and public land rights
are held in common by society
and freely available, so no
incentive exists to maintain
or use them carefully; the result

is overuse, degradation, and
pollution.
U
UNINSURABLE RISK An event that
would result in a loss and whose
occurrence is uncontrollable and
unpredictable; insurance compa-
nies are not willing to sell insur-
ance against such a loss.
UNIT ELASTICITY Demand or sup-
ply for which the elasticity coeffi-
cient is equal to one; means that
the percentage change in the
quantity demanded or supplied
is equal to the percentage change
in price.
USURY LAWS State laws that spec-
ify the maximum legal interest
rate at which loans can be made.
UTILITY The want-satisfying
power of a good or service; the
satisfaction or pleasure a con-
sumer obtains from the consump-
tion of a good or service (or from
the consumption of a collection of
goods and services).
UTILITY-MAXIMIZING RULE To
obtain the greatest utility the con-
sumer should allocate money
income so that the last dollar
spent on each good or service
yields the same marginal utility.
V
VALUE ADDED TAX (VAT) A tax
imposed on the difference
between the value of the products
sold by a firm and the value of
the goods purchased from other
firms to produce the product; used
in several European countries.
VARIABLE COSTS Costs that in total
increase when the firm increases
its output and decrease when it
reduces its output.
VENTURE CAPITAL Financial capital
lent in return for a share in the
business.
VERTICAL AXIS The “up–down” or
“north–south” axis on a graph
or grid.
VERTICAL INTERCEPT The point at
which a line meets the vertical
axis of a graph.
VERTICAL MERGER The merger of
firms engaged in different stages
of production process of a final
product.
glossary 539
VERY LONG RUN A period in which
technology can change and in
which firms can develop and offer
entirely new products.
W
WAGE DIFFERENTIALS The differ-
ence between the wage received
by one worker or group of work-
ers and that received by another
worker or group of workers.
WAGE DISCRIMINATION The
payment of a lower wage to
members of a less-preferred
group than to members of a
more-preferred group for the
same work.
WORLD TRADE ORGANIZATION (WTO)
An organization established in
1994, replacing GATT, to oversee
the provisions of the Uruguay
Round and resolve any disputes
stemming from it.
X
X-INEFFICIENCY Failure to
produce any specific output at
the lowest average (and total)
cost possible.
Index
A production possibilities curve,
ability
differences in, and specialization,
80
entrepreneurial, 28–29
and income inequality, 441
to purchase, 156
and wage differentials, 394–395
ability-to-pay principle, 493–494
above-equilibrium wages, 398
absolute advantage, 108
absolute poverty, 447
abstractions, 9
adverse selection problem, 477
advertising
brand-name recognition, 317
monopolistic competition, 276
monopoly power via, 297
negative effects, 297
oligopoly, 296–298
positive effects, 296–297
self-canceling, 297
aggregate, defined, 11
agribusiness, 515
agriculture
agribusiness, 515
bolstering demand, 521
Canadian Wheat Marketing
Board, 518
crop restriction, 521
deficiency payments, 519–521
domestic demand, 521
egg industry, 525
farm policy, economics of,
516–517
farm subsidies, 516–517
foreign demand, 521
“gasohol,” 521
long-run farm problem, 510
marketing boards, 517–518
offers to purchase, 518–519
price supports. See price
supports
short-run farm problem, 510–513
surpluses, reduction of, 521
allocative efficiency
defined, 30
monopolistic competition,
280–281
monopoly, 259
oligopoly, 298
at the margin, 6
34–36 auto antitheft device, 479–480
pure competition, 237 automatic teller machines (ATMs),
technological advances, 322–323 370–371
anti-combines legislation average
Act of 1889, 337 fixed costs, 194
balance of trade, 339 product, 188
civil law framework, 338 revenue, 216
Combines Investigation Act, total costs, 195, 198–199, 204, 237
337–338 variable costs, 194–195, 198–199
Competition Act, 338 Ayres, Ian, 479–480
Competition Tribunal, 338
defined, 336 B
enforcement issues, 339–340 backflows, 410–411
evolution of, 337–338 balance of trade
recent cases, 338–339 anti-combines legislation, 339
technological advances, 339–340 as goal, 10
anti-combines policy, 294 bank loans, 310
defined, 335 barriers to entry
historical background, 335–336 defined, 247
antidiscrimination policies economies of scale, 247–248
employment equity, 407–408 essential resources, ownership or
indirect, 406–407 control of, 249
strong economy, promotion of, legal, 248–249
406–407 licenses, 248–249
visible minorities, education and natural monopoly, 248
training, 407 oligopoly, 283
women, education and training, patents, 248
407 pricing, 249
antimonopoly legislation. See anti- product differentiation, 278
combines legislation research and development, 248
appreciation (of the dollar), 113 strategic, 249
Argentina, production possibilities barter, 80–81
curve, 40 Bayer Chemicals, 104
assumptions beer industry, 299–300
ceteris paribus, 20–21 benefits-received principle, 493
other-things-equal, 8–9, 20–21 biases, 12–13
production possibilities table, bilateral monopoly
30–31 defined, 390
asymmetric information desirability, 391
adverse selection problem, 477 indeterminate outcome, 390–391
buyers, 476–478 black markets, 147
Consumer Reports, 478 blocked entry, 246
defined, 474 bonds, 183, 310
gasoline market, 475 bonuses, 398
moral hazard problem, 476–477 Boudreaux, Donald, 121
product warranties, 478 brand names, 275, 298, 317
qualification, 478 break-even point, 219
sellers, 475–476 budget constraints, 160
surgeons, licensing of, 475–476 budget line, 173–174
workplace safety, 477–478 bureaucracy, 491–492
 index 541

business-policy decisions, 28 cheat, incentive to, 287 and “invisible hand,” 86

business sector Chicago Board of Trade, 50 monopolistic. See monopolistic
corporation, 181, 182–183 China competition
firm, 181 central planning, reduced reliance nonprice, 276
industry, 181 on, 43 pure. See pure competition
legal forms of businesses, 181–183 emerging trader, 105 requirements of, 78
partnership, 181, 182 choice and social regulation, 346
plant, 181 and economic perspective, 4 Competition Act, 338
sole proprietorship, 181, 182 freedom of, 76–77 Competition Tribunal, 338
buyers, number of, 54–55 key concept, 3 complementary goods, 55, 141
buyout, 318 need for, 31–32 concentration ratio, 284–285
present, 39–40 conglomerate mergers, 336–337
C circular flow model, 8, 43 conservative position on freedom,
Canada Pension Plan, 449 defined, 43 504
Canadian economy international trade, 106–107 constant-cost industry, 234–235
foreign ownership, 93–94 key graph, 44 constant returns to scale, 203
sectoral shifts over time, 92–93 product market, 43 consumer
Canadian Wheat Marketing Board, and public sector, 91–92 decision-making process, 162–163
518 resource market, 43 demand, 83
capital Coase theorem, 462–463 demand schedule, 164–165
accumulation, 86 Coca-Cola Co., 104 dollar votes, 83
allocation, and interest, 426–427 coincidence of wants, 81 expectations, 55–56
defined, 28 collusion fast food, 15
efficient, 202 cheating and, 294 goods, 28, 31
financial, 28 covert, 293 sovereignty, 83
flows, 100 demand and cost differences, 294 subsidize, 88
goods. See capital goods firms, number of, 294 surplus, 241, 325–326
human, 395 game theory model, 287 consumer choice
increase in price, 362 legal obstacles, 294 allocation rule, 163–164
money, 28 obstacles to, 294 applications, 166–168
physical, per worker in Canada, overt, 292–293 and budget constraints, 160
377 potential entry, 294 budget line, 173–174
real, 28 recessions, 294 cash gifts, 168
venture, 310 tacit understandings, 293 compact disc takeover, 166
capital goods Combines Investigation Act, criminal behavior, 169
vs. consumer goods, 28 337–338 decision-making process, 162–163
defined, 31 command system, 42–43 diamond-water paradox, 167
in market system, 79 commissions, 397 indifference curves, 174–176
capitalism communications technology, 104 inferior options, 163
laissez-faire, 42 communism, 42–43 marginal utility per dollar,
pure, 42 compact disc takeover, 166 161–162
cartel, 292–293 comparative advantage noncash gifts, 168
cash gifts, 168 defined, 109 preferences, 160
causation gains from trade, 110–111 and prices, 160
vs. correlation, 14 specialization and, 108–111 property crimes, 169
fallacies, 14 comparative costs, 109–110 rational behavior, 160
cause-effect hypotheses, 6–7 compensating differences, 395 utility maximization, and
ceteris paribus, 20–21 competition demand curve, 164–166
change and abuse of power, 78 utility-maximizing rule, 160–161
in demand, 57 defined, 78 value of time, 167–168
market system, accommodation and discrimination, 403 Consumer Reports, 478
in, 84–85 foreign, increased, 298 consumption
in quantity demanded, 57 global, increased, 120 and income, 19
in quantity supplied, 61 imperfect, 214, 356–359 substitution in, 55
in supply, 61 import, 285 copyright, 317
chartered bank mergers, 339 interindustry, 285 corporate income tax, 495, 500–501
542 index
corporation
advantages, 182–183
bonds, 183
conflict of interest, 184
defined, 181
disadvantages, 182–183
limited liability, 183
principal-agent problem, 184–185
stocks, 183
correlation, vs. causation, 14
cost-benefit analysis, 460–461
cost curve
externalities, and shifts, 470
long run, 200–201
shifts in, 199
costs
average fixed, 194
average total, 195
average variable, 194–195
comparative, 109–110
deficiency payments, 520–521
discrimination, 400
economic. See opportunity cost
environmental, and deficiency
payments, 520
explicit, 184–185, 429
fixed, 192
immigration, 410
implicit, 184–185, 429
industrial regulation, 341
marginal. See marginal costs
marginal resource, 356
minimization of, 353
in monopoly, 259
normal profit, 185–186
per-unit, 194–195
production, 192–196
resource, 365
spillover. See spillover costs
sunk, 208–209
total, 192–194, 365
trade interventions, 116
transition, of global warming, 474
variable, 192
craft union model, 387–388
creative destruction, 85, 323–324
credit, determination of price of, 434
credit card interest ceilings, 148
criminal behavior, 169
crop restriction, 521
cross elasticity of demand
complementary goods, 141
defined, 140
formula, 140
independent goods, 141
substitute goods, 141
crowding model, 404–406
Cuba, centrally planned economy,
43
D law of, 51–52
daily newspapers, 206
De Beers diamond monopoly,
268–269
deadweight loss, 328
deck of cards, 121
declining birthrates, 45
decreasing-cost industry, 236–237
decriminalization of illegal drugs,
137–138
deficiency payments
defined, 519
elasticity of supply and demand,
519
environmental costs, 520
international costs, 520–521
vs. offers to purchase, 519–520
resource overallocation, 520
deficit, trade, 103
definitions, 13
demand
buyers, number of, 54–55
change in, 53–54, 57
change in, and equilibrium, 65
change in quantity demanded, 57
complementary goods, 55
consumer, 83
cross elasticity of. See cross
elasticity of demand
decrease, and decrease in supply,
66–67
decrease, and increase in supply,
65
decrease in, 53–54
defined, 50
derived, 83, 353–354
determinants of, 53
economic rent, 419
elastic, 128, 132–133
elastic product, 127
excess, 62
expectations, changes in, 55–56
and income, 55
income effect, 51
income elasticity of. See income
elasticity of demand
increase, and decrease in supply,
65
increase, and increase in supply,
66
increase in, 53
independent goods, 55
inelastic, 128, 133
inelastic product, 127
inferior goods, 55
and interest, 424–425
loanable funds, 423–424
marginal utility, 51
and marginal utility, 159
market, 52–53
monopoly, 249–253
normal goods, 55
perfectly elastic, 129
perfectly inelastic, 129
pink salmon example, 67–68
price elasticity. See price elasticity
of demand
prices of related goods, 55–56
product, changes in, 359–360
public goods, 457–458
and pure competition, 216–217
recyclable glass, 471–472
recycling, incentive for, 472
relatively elastic product, 127
relatively inelastic product, 127
resource. See resource demand
shifters, 53
and short-run farm problem,
511–513
substitute goods, 55
substitution effect, 51–52
tastes, 54
and taxation, 143–144
and time, 135–136
unit elasticity, 128, 133
unrelated goods, 55
demand curve
budget lines and, 177–178
defined, 52
and elasticity, 132
kinked, 289
market, 52, 249
monopolistic competition,
276–277
monopoly, 249
and utility maximization, 164–166
demand-enhancement model,
385–387
demand schedule, 50
Department of Consumer and
Corporate Affairs, 338
dependent variable, 18, 19–20
depreciation (of the dollar), 113
deregulation, 342–343
derived demand, 83, 353–354
determinants
of demand, 53

price elasticity of demand,
135–136
resource demand, 359–363
of supply, 58–59
diamond-water paradox, 167
differentiated oligopoly, 283
diffusion, 306
dilemma of regulation, 268
diminishing marginal product, law
of. See law of diminishing
returns
diminishing returns, law of, 188–190
direct relationship, 19
discrimination
coefficient, 401–402
competition, 403
costs, 400
crowding model, 404–406
economic analysis, 400–406
employment, 400
human capital, 400
and immigration, 408–411
income inequality, 441
labour market, 399–400
occupational, 400
occupational segregation, 404–406
policies against. See
antidiscrimination policies
and production possibilities
curve, 41
reverse, 408
statistical, 403–404
symphony orchestras, 412
taste-for-discrimination model,
400–401
types of, 399–400
visible minority-white wage ratio,
402–403
wage, 399
wage differentials, 396
diseconomies of scale, 203
divisible goods, 89
division of labour, 80
divorce insurance, and moral
hazard problem, 476
divorce rates, 46
dollar
appreciation, 113
depreciation, 113
votes, 83
dollar-yen market, 112
dual rental market, 148
durability of product, 136
E uninsurable risk, 430–431
economic costs. See opportunity cost
index 543
economic efficiency, 84 application, 420–421
economic freedom, 10 defined, 418
economic goals, 10–11 demand, changes in, 419
economic growth differences, 421
defined, 38 incentive function of price, 419
as goal, 10 land, alternative uses of, 421–422
unions, effect of, 389 land rent as surplus payments,
economic methodology 419–420
abstractions, 9 perfectly inelastic supply, 419
cause-effect hypotheses, 6–7 productivity differences, 421
generalizations, 8 single tax on land, 420–421
graphical expression, 9 economic resources
“other-things-equal” assumption, capital, 28
8–9 defined, 28
principles, 7–9 flows, 100
scientific method, 6 increases in resource supplies, 37
terminology, 8 labour, 28–29
theoretical economics, 7 land, 28
economic perspective payments, 29
causation, 14 prices, 59–60
causation fallacies, 14 real flow of, 43
choice, 4 reallocation process, 90
correlation, 14 relative scarcity, 29
definitions, 4, 13 underallocation, and spillover
fallacy of composition, 13 benefits, 88
fast food consumers, 15 economic security, 10
loaded terminology, 13 economic system
marginal analysis, 5 command system, 42–43
objective thinking, pitfalls to, defined, 42
12–13, 12–14 Four Fundamental Questions, 82
post hoc, ergo propter hoc fallacy, 14 market system, 42
rational self-interest, 5 economics
scarcity, 4 of agriculture. See agriculture
economic problem defined, 3
defined, 27 fundamentals, 27–28
and economics, defined, 29 of immigration, 408–410
resource categories, 28–29 normative, 12
scarce resources, 28 policy, 9–11
unlimited wants, 27–28 positive, 12
economic profit, 222, 229–230, 233 theoretical, 7
defined, 429 economies of scale
entrepreneur, role of, 429–430 barriers to entry, 247–248
explicit costs, 429 daily newspapers, 206
functions of, 432 defined, 202
implicit costs, 429 efficient capital, 202
innovation, 431 examples of applications, 203–206
insurable risk, 430 General Motors, 206–207
monopoly, 431 labour specialization, 202
normal profit, 430 learning by doing, 202
opportunity cost, 186 managerial specialization, 202
resource allocation, 432 manufacturing industries, 203
sources, 430–432 and minimum efficient scale, 207
static economy, 430 monopoly, 259–260
total output, 432 oligopoly, 283
successful startup firms, 203–206
economic rent Verson stamping machine, 206
544 index
education
antidiscrimination policies, 407
income inequality, 441
as spillover benefit, 88
wage differentials, 395
effect
income, 51, 156, 165–166
output, 361
special-interest, 489–490
substitution, 51–52, 156, 165–166,
361
efficiency
allocative. See allocative
efficiency
and bureaucracy, 491–492
consumer surplus, 325–326
deadweight loss, 328
economic, 84
efficient allocation, 240
full production, 30
as goal, 10
and income inequality, 446
and increased foreign
competition, 298
industrial regulation, 341
limit pricing, 299
loss of a tax, 498–500
market equilibrium, 327
market system, 86
monopolistic competition,
280–281
monopoly, 257–259
oligopoly, 298–299
overallocation, 239
overproduction, 328
producer surplus, 326–327
productive. See productive
efficiency
and pure competition, 237–240
in pure monopoly, 257–259
and technological advance, 299
technological advances, 322–324
underallocation, 239
underproduction, 328
wages, 398
efficient allocation, 240
efficient capital, 202
egg industry, 525
elastic demand, 128, 132–133
elastic product, 127
elasticity
cross, of demand, 140–141
demand. See price elasticity of
demand
and ease of substitution, 364
and efficiency loss of a tax,
499–500
and efficiency payments, 519
income, of demand, 141–142
and marginal utility, 159
product demand, 364–365
resource demand, 363–365
supply, 138–140
tax incidence, 143–145, 497–498
and taxes, 143–145
unions, in effect of, 389–390
employment
discrimination, 400
equilibrium in monopsony, 384
equity, 407–408
full. See full employment
occupational employment trends,
363
resource, 355–356
Employment Insurance, 450
enterprise, freedom of, 76–77
entrepreneurial ability, 28–29
entrepreneurs
buyout, 318
defined, 307
and economic profit, 429–430
future, anticipation of, 308–309
start-ups, 308
the environment
costs of deficiency payments, 520
pollution, as spillover cost, 87
equality-efficiency trade-off,
446–447
equation of linear relationship,
22–23
equilibrium
budget line, 173–174
demand, change in, 65
employment, in monopsony,
384
indifference curves, 174–176
key graph, 64
labour markets, 381–382
long-run, 232–234
mathematics of, 73–74
pink salmon example, 67–68
position, 176
price, 63, 84, 229–231
quantity, 63
quantity, and externalities,
469–470
rationing function of prices, 63–65
supply, change in, 65
supply decrease and demand
decrease, 66–67
supply decrease and demand
increase, 65
supply increase and demand
decrease, 65
supply increase and demand
increase, 66
at tangency, 176
wage, in monopsony, 384
equitable distribution of income, 10
ethics, and resource market, 353
euro, 119
European Union
defined, 118
euro, 119
trade bloc, 118–119
excess capacity, 281
excess demand, 62
exchange rate
appreciation (of the dollar), 113
changing, 112–113
defined, 111
depreciation (of the dollar), 113
excise taxes, 501–502
exclusion principle, 89, 457
exclusive unionism, 387–388
expectations
consumer, 55–56
price, 60
expected-rate-of-return curve, 311
explicit costs, 184–185, 429
exports, and subsidies, 115
externalities
Coase theorem, 462–463
cost curves, shifts in, 470
defined, 461
direct controls, 464
and equilibrium quantity, 469–470
externality rights, market for, 467
government intervention, 464–466
law of conservation of matter and
energy, 470–471
lawsuits, 463–464
liability rules, 463–464
litigation, 463–464
market-based approach to
spillover costs, 466–474
market operation, 467–468
optimal amount of externality
reduction, 468–470
solid-waste disposal, 470–473
specific taxes, 464–465
spillover benefits, 462
and spillover costs, 462
subsidies, 465–466
tragedy of the commons, 466–467

externality reduction, 468–470
externality rights, market for, 467
F as goal, 10
factors of production, 29
fair-return price, 267–268
fallacy of composition, 13
fallacy of limited decisions, 504–505
farm policy, 516–517, 523
see also price supports
fast food consumers, 15
fast-second strategy, 317
financial flows, 101
financial institutions, 424
financial linkages, 103
firm
average revenue, 217
defined, 82, 181
equilibrium price, 229–231
vs. industry, 230–231
marginal revenue, 217
market restraints on freedom, 83
minimum efficient scale, 207
planning curve, 201
price-taker, 215
research and development
financing, 310
revenue schedule, 216
size of, and costs, 200
successful startup, 203–206
total revenue, 217
fixed costs, 192
fixed plant, 187
foreign exchange market
competitive, 111
defined, 111
dollar-yen market, 112
domestic prices, linkages to,
111–112
foreign prices, linkages to,
111–112
foreign ownership, in Canada,
93–94
formulation of policy, 9–10
Four Fundamental Questions, 82–85
free lunch, 346
free-rider problem, 89
free-trade zones
European Union, 118
trade bloc, 118–119
freedom
of choice, 76–77
of enterprise, 76–77
individual, 504–505
market system, 86
full employment
available resource, use of, 29
defined, 29
vs. unemployment, 411
future, anticipation of, 308–309
Future and its Enemies (Postrel), 121
future possibilities, 39–40
G credit card interest ceilings, 148
gains from trade, 110–111
game theory model
cheat, incentive to, 287
collusion, 287
defined, 286
mutual interdependence, 286–287
payoff matrix, 286
“gasohol,” 521
gasoline market, 475
General Agreement on Tariffs and
Trade (GATT), 117–118
General Motors, 206–207
generalizations
choice, need for, 32
defined, 8
geographic immobility, 396
geographic specialization, 80
George, Henry, 420
global warming, 473–474
goods
capital, 28, 31, 79
complementary, 55, 141
consumer, 28, 31
divisible, 89
flows, 100
for the future, 39–40
independent, 55, 141
inferior, 55, 142
investment, 28
normal, 55, 142
for the present, 39–40
private, 89, 457
public. See public goods
quasi-public, 89–90
substitute, 55, 141
unlimited wants, 28
unrelated, 55
via government, 89
Goods and Services Tax, 502
government failure
benefits of vote seeking, 490
bundled choice, 491
bureaucracy, and inefficiency,
491–492
defined, 489
index 545
hidden costs of vote seeking, 490
imperfect institutions, 492
limited choice, 491
rent seeking behaviour, 490
special-interest effect, 489–490,
492
government-set prices
black markets, 147
controversial tradeoffs, 149–150
graphical analysis, 145–146
price ceilings, 145–149
price floors, 148–149
rationing problem, 146
rent controls, 147–148
governments
circular flow model, 91–92
cross elasticity of demand, 141
dilemma of regulation, 268
direct controls, 464
export subsidies, 115
failure. See government failure
import quotas, 115
income maintenance system,
449–450
income redistribution, 440
and individual freedom, 504–505
and international trade, 114–116
intervention by, 464–466
key concept, 3
in market system, 79
and monopoly, policy options,
262
non-tariff barriers, 115
protective tariffs, 114–115
provision of goods, 89
reallocation process, 90
regulated monopoly, 266–268
scientific research, 309
spending, reduced, 461
subsidies, 465–466
trade impediments, 114–115
wage differentials, 396
graphical expression, 9
graphs
ceteris paribus, 20–21
construction of, 18–19
dependent variable, 18, 19–20
direct relationship, 19
equation of linear relationship,
22–23
horizontal axis, 18
independent variable, 18, 19–20
infinite slope, 22
inverse relationship, 19
546 index
marginal analysis, and slopes,
21–22
measurement units, and slopes,
21
negative slope, 21
nonlinear curve, slope of, 23
positive slope, 21
slope of straight line, 21
stock market crashes, 20
vertical axis, 18
vertical intercept, 22
zero slope, 22
Great Depression, 40, 116
growing economy, 36
Guaranteed Income Supplement,
450
guiding function of prices, 84–85
H distribution. See income
Herfindahl index, 285
highway construction, 460–461
homogeneous oligopoly, 283
Hong Kong, 104
horizontal axis, 18
horizontal merger, 336
household, defined, 82
human capital
discrimination, 400
investment in, 395
human organs, 150–151
I proportion of, 135
illegal drugs, decriminalization of,
137–138
illegal immigrants, 408
imitation problem, 316
immigration
backflows, 410–411
complications, 410–411
costs, 410
economics of, 408–410
full employment, 411
illegal immigrants, 408
income inequality, 444
income shares, 410
legal immigrants, 408
modifications, 410–411
remittances, 410–411
two views, 411
unemployment, 411
wage rates, 408–409
world output, 408–409
immunization, as spillover benefit,
88
imperfect competition, 214,
356–359
implicit costs, 184–185, 429
import competition, 285
imports, and quotas, 115
in-kind transfers, 440
inadequate information. See
asymmetric information
incentive function of price, 419
incentives
income inequality, 446
key concept, 3
market system, 86
research and development,
316–318
inclusive unionism, 388–389
income
changes, and budget line, 173
and consumption, 19
and demand, 55
distribution
effect, 51, 156, 165–166
equality, 445–447
growth of, 142
and immigration, 410
inequality. See income inequality
inferior goods, 55
interest, 29
maintenance system, 449–450
mobility, 440, 448–449
money flow of, 43
normal goods, 55
rental, 29
shares, 432–433
transfer off, in monopoly, 259
income distribution
equitable, 10
by income category, 438
inequality of, 370
marginal productivity theory,
369–370
market imperfections, 370
by quintiles, 438
utility-maximization, 445–446
income elasticity of demand
defined, 141
formula, 141
inferior goods, 142
insights into economy, 142
normal goods, 142
income inequality
and ability, 441
case for, 446
causes, 441–442
connections, 442
defined, 438
and demographic changes,
443–444
discrimination, 441
and education, 441
and efficiency, 446
equality, and maximization of
total utility, 445–446
government redistribution, 440
growing inequality, causes of,
443–444
highly skilled workers, greater
demand for, 443
immigration, 444
and incentives, 446
income category distribution, 438
income mobility, 440
international trade, 444
Lorenz curve, 438–439
and luck, 442
market power, 442
measurement of, 438–441
misfortune, 442
non-cash transfers, 440
preferences, differences and,
441–442
quintiles, distribution by, 438
and risk, 441–442
and time, 440
and training, 441
trends, 443–444
unionism, decline in, 444
wealth, unequal distribution of,
442
increasing-cost industry, 235–236
independent goods, 55, 141
independent variable, 18, 19–20
indifference curves
convex to the origin, 175
defined, 174
downsloping, 174–175
utility, measurement of, 177
indifference map, 175–176
individual freedom, 504–505
industrial concentration, defined,
335
industrial expansion and
contraction, 142
industrial regulation
costs, 341
inefficiency, 341
legal cartel theory of regulation,
342
monopoly, perpetuation of,
341–342
natural monopoly, 340–341
problems with, 341–342

public interest in theory of
regulation, 340–341
industrial union model, 388–389
industry, 181
industry, vs. firm, 230–231
industry concentration measures
concentration ratio, 284–285
Herfindahl index, 285
import competition, 285
interindustry competition, 285
inefficiency
direct methods of production, 79
and roundabout production, 79
inefficient voting outcomes, 484–486
inelastic demand, 128, 133
inelastic product, 127
inferior goods, 55, 142
infinite slope, 22
inflation, 4
inflation-unemployment
relationship, 4
information failures. See asymmetric
information
information flows, 100
initiative, 28
innovation
see also research and development
brand-name recognition, 317
copyright, 317
creative destruction, 323–324
defined, 305–306
and economic profit, 431
within existing firms, 308
fast-second strategy, 317
future, anticipation of, 308–309
increased profits, 313–316
learning by doing, 317
new products, 314–315
process, 306, 315–316
product, 306, 313–315
reduced cost, 315–316
social regulation, effect of, 346
time lags, 317–318
trade secrets, 317
trademarks, 317
innovators, 28–29, 308
input substitution, 370–371
insurable risk, 430
interest
capital allocation, 426–427
defined, 422
demand, changes in, 424–425
demand for loanable funds,
423–424
financial institutions, 424
income, 29
loanable funds theory of interest,
422–423
money not resource, 422
nonmarket rationing, 428
other participants, 425
percentage, 422
and research and development
spending, 427
supply, changes in, 424
supply of loanable funds, 423
and total output, 426
usury laws, 428–429
interest groups, 486
interest rate
loan size, 426
market imperfections, 426
and maturity, 425–426
nominal, 427
pure rate of interest, 426
range of, 425–426
real, 427
and risk, 425
role of, 426–427
interest-rate cost-of-funds curve,
310
interindustry competition, 285
international costs of deficiency
payments, 520–521
international linkages, 100–101
international trade
brand names, top, 298
circular flow model, 106–107
communications technology, 104
comparative advantage, 108–111
dependence, 102
export subsidies, 115
financial linkages, 103
free-trade zones, 116–120
gains from trade, 110–111
and governments, 114–116
import quotas, 115
income inequality, 444
increased competition, 120
industry concentration measures,
285
Japan, 104
multinational corporations, 104
new participants, 104–106
non-tariff barriers, 115
North America, 104
participants in, 104–106
price supports, 524
and production possibilities
curve, 40
protective tariffs, 114–115
rapid growth, 103–104
index 547
specialization, 108–111
tariffs, general decline in, 104
terms of trade, 109–110
trade agreements, 116–120
trade deficit, 103
trade impediments, 114–115
trade patterns, 101, 103
trade surplus, 103
transportation technology,
103–104
two-way street, 102
volume, 101, 102
Western Europe, 104
Internet, 329–330
invention, 305
inverse relationship, 19
inverted-U theory, 321–322
investment
defined, 28
goods, 28
in human capital, 395
“invisible hand,” 86, 240
invisible poor, 449
J
Japan
and international trade, 104
production possibilities curve, 40
K
key concepts, 3–4
key graphs
average total cost curve, 197
average variable cost curve, 197
circular flow diagram, 44
equilibrium price and quantity, 64
kinked demand curve, 289
law of diminishing returns, 191
long run average-total-cost curve,
204
long-run equilibrium position of
competitive firm, 238
marginal cost curve, 197
marginal utility, 158
monopolistic competition, 279
P=MC rule, and short-run supply
curve, 228
production possibilities curve, 33
pure monopoly, 254
purely competitive labour
market, 380
short-run profit-maximizing
position of purely
competitive firm, 223
total utility, 158
key money, 148
548 index

kinked demand curve, 289, 290
kinked-demand theory
criticisms of, 291
kinked demand curve, 289, 290
price inflexibility, 290–291
price war, 291
L law of supply, 58
labour
see also wage differentials
capital, increase in price, 362
defined, 28
entrepreneurial ability, 28–29
flows, 100
highly skilled workers, 443
market demand for. See labour
demand
market supply, 381
nominal wage, 376
noncompeting groups, 393–394
occupational licensing, 388
quality, 378
real wage, 376
specialization, 202
unions. See unions
wages, 29
labour demand
changes in, 363
input substitution, 370–371
purely competitive market, 379
labour markets
discrimination, 399–400
equilibrium, 381–382
in monopsony, 382–385
purely competitive, 379–382
statistical discrimination, example
of, 404
visible-minority workers, 402–403
workplace safety, and asymmetric
information, 477–478
laissez-faire, 42
land
see also economic rent
defined, 28
rent, 419–420
law of conservation of matter and
energy, 470–471
law of demand
common sense and, 156
defined, 51–52
income effect, 156
substitution effect, 156
law of diminishing marginal utility,
159
law of diminishing returns
defined, 188
graphical portrayal, 190
key graphs, 191
rationale, 188–189
in short run, 227–229
tabular example, 189–190
law of increasing opportunity cost,
32–34
lawsuits, 463–464
learning by doing, 202, 317
least-cost combination of resources,
366–367
least cost production, 368
legal barriers to entry, 248–249
legal cartel theory of regulation, 342
legal immigrants, 408
legislation
anti-combines. See anti-combines
legislation
antimonopoly. See anti-combines
legislation
and spillover costs, 88
usury laws, 428–429
Levitt, Steven, 479–480
liability rules, 463–464
liberal position on freedom, 504–505
licenses, 248–249
limit pricing, 295, 299
limited liability, 183
limited resources, 4
linear relationship, equation of,
22–23
litigation, 463–464
loaded terminology, 13
loanable funds. See interest
loanable funds theory of interest,
422–423
localized markets, 285
location, 275
Logic of Collective Action (Olson), 95
logrolling, 486
Lojack, 479–480
long run
cost curve, 200–201
defined, 140, 187
monopolistic competition, 278
price elasticity of supply, 140
production costs, 200–207
profit maximization, 231–237
long-run adjustments, 187
long-run equilibrium, 232–234
long-run farm problem
agribusiness, 515
consequences, 514–515
defined, 510
income-inelastic demand, 514
lagging demand, 514–515
population growth, 514
supply increases, 513–514
technological advances, 513–514
long-run supply
constant-cost industry, 234–235
curve, 234–235
decreasing-cost industry, 236–237
increasing-cost industry, 235–236
perfectly elastic, 234–235
Lorenz curve, 438–439
luxuries, 27, 135
M
macroeconomics, defined, 11
managerial specialization, 202
margin, as key concept, 3
marginal analysis
defined, 5
scarcity, 5
and slope, 21–22
too much of good thing, 5–6
marginal benefits, 5
marginal costs
and average total cost, 198–199
and average variable costs,
198–199
calculation, 195–196
defined, 5, 195, 199
graphical portrayal, 196
marginal decisions, 196
and marginal product, 196–198
and short-run supply, 226–231
marginal product, 188, 196–198, 355,
364
marginal productivity theory of
income distribution, 369–370
marginal rate of substitution, 175
marginal resource costs, 356
marginal revenue, 217, 250–251
marginal revenue product, 354–355
marginal revenue product schedule,
355–356
marginal revenue productivity, 393
marginal utility
and consumer choice, 161–162
consumer choice theory, 160–164
defined, 51, 157
and demand, 159
diamonds, 167
and elasticity, 159
key graphs, 158
per dollar, 161–162
terminology, 157
total utility, 157
water, 167

market demand, 52–53
market demand curve, 52, 88
market equilibrium, 73–74
market failure
asymmetric information, 474–478
collective action, need for, 95
defined, 457
externalities. See externalities
free-rider problem, 89
government, need for, 95
public goods, 89
quasi-public goods, 89–90
reallocation process, 90
spillover benefits, 88–89
spillover costs, 87–88
types of, 87
market imperfections, 370, 395, 426
market period, 139–140
market power, 442
market restraints on freedom, 83
market segregation, 263
market structures
inverted-U theory, 321–322
and technological advances,
319–322
types of, 214
market system
capital accumulation, 86
capital goods, 79
characteristics of, 76–81
competition, 78
consumer sovereignty, 83
derived demand, 83
division of labour, 80
dollar votes of consumer, 83
dynamic nature of, 84
efficiency, 86
enterprise, freedom of, 76–77
Four Fundamental Questions,
82–85
freedom, 86
freedom of choice, 76–77
geographic specialization, 80
government, 79
guiding function of prices, 84–85
how will change be
accommodated, 84–85
how will goods and services be
produced, 83–84
incentives, 86
market failure, 87–90
market restraints on freedom, 83
markets, 78–79
medium of exchange, 80
and money, 80–81
organizing mechanism, 79
index 549
prices, 78–79 key concept, 4
private property, 76 in market system, 80–81
progress, promotion of, 85–86 medium of exchange, 80
roundabout production, 79 not resource, 422
self-interest, 77–78 paper, 81
and specialization, 79–80 money-income determination, 353
and technology, 79, 85 monopolistic competition
what will be produced, 82–84 advertising, 276
who will get goods and services, allocative efficiency, 280–281
84 in Canada, 276
at work, 82–86 collusion, lack of, 274
marketing boards, 517–518 complications of normal profit
markets outcome, 278
black, 147 defined, 214, 274
defined, 42, 50 demand curve, 276–277
human organs, 150–151 easy entry and exit, 276
key concept, 3 efficiency, 280–281
labour. See labour markets excess capacity, 281
localized, 285 independent action, 274
and prices, 78–79 key graphs, 279
product, 43 long run, 278
resource, 43 losses, 277–278
maturity, and interest, 425–426 nonprice competition, 276
MC=MB rule, 461 normal profit outcome, 278
measurement units, and slope, 21 price, control over, 275–276
median-voter model price elasticity of demand, 276
defined, 487–488 prices in, 276–281
example, 488 product differentiation, 274–276,
implications, 488–489 278
real-world applicability, 488 product variety, 281–282
medium of exchange, 80 productive efficiency, 280–281
mergers profits, 277–278
chartered bank, 339 relatively large number of sellers,
conglomerate, 336–337 274
horizontal, 336 short run, 276
oligopoly, 283–284 small market shares, 274
types of, 336–337 technological advances, 319–320
vertical, 336 monopoly
Mexico, and production possibilities allocative efficiency, 259
curve, 40 assessment of, 262
microeconomics, defined, 11 barriers to entry, 247–249
Microsoft antitrust case, 347–348 bilateral, 390–391
midpoint formula, 129–130 cost assumption, 253
minimum efficient scale, 207 cost complications, 259
minimum wage creative destruction, 85
case against, 391–392 De Beers diamond monopoly,
conclusions, 392 268–269
defined, 138, 391 demand, 249–253
evidence about, 392 dilemma of regulation, 268
support for, 392 economic effects, 257–262
minus sign, elimination of, 128 economic profit, 431
Mitsubishi, 104 economies of scale, 259–260
money examples of, 246
capital, 28 fair-return price, 267–268
defined, 81 and highest price, myth of, 256
inflation, 4 income transfer, 259
550 index
legitimate economic concerns, 262
losses, possibility of, 256–257
marginal revenue, 250–251
market demand curve, 249
MR=MC rule, 253–255
natural, 248, 266, 340–341
network effects, 260
output, determination of, 253–257
perpetuation of, 341–342
policy options, 262
price, determination of, 253–257,
256–257
price discrimination, 263–266
price elasticity of demand,
252–253
price-maker, 251
productive efficiency, 257
profit maximization, 253
pure. See pure monopoly
regulated, 266–268
rent-seeking behaviour, 261
simultaneous consumption, 259
socially optimal price, 267
study of, objectives, 246
supply curve and, 255–256
and technological advances,
261–262
total profit, 256
total-revenue test, 252–253
X-inefficiency, 260–261
monopsony
defined, 382
degrees of power, 382
employment, equilibrium, 384
equilibrium wage, 384
examples of, 384–385
higher wage, 383–384
upward-sloping labour supply,
382–383
moral hazard problem, 476–477
most-favoured-nation clauses, 117
MR=MC rule, 221, 253–255
MRP=MRC rule, 356
multinational corporations, 104
mutual interdependence, 283,
286–287
N covert collusion, 293
National policy (1879), 94
natural monopoly, 207, 248, 266,
340–341
natural resources, 377
necessities, 27, 135
negative slope, 21
Nestlé, 104
network effects, 260 firms, number of, 294
new products, 314–315 game theory, 286–288
nominal interest rate, 427 Herfindahl index, 285
nominal wage, 376 homogeneous, 283
non-cash transfers, 440 import competition, 285
non-tariff barriers, 115 increased foreign competition,
noncash gifts, 168 298
noncompeting groups, 393–394 industry concentration measures,
nonlinear curve, slope of, 23 284–285
nonprice competition, 276 interindustry competition, 285
nonrivalrous consumption, 259 kinked-demand theory, 288–291
normal goods, 55, 142 limit pricing, 299
normal profit, 185–186, 219, 430 localized markets, 285
normative economics, 12 mergers, 283–284
Nortel Networks, 104, 107 models of, 288–295
North American Free Trade monopoly power, desire for, 284
Agreement (NAFTA), 119–120 mutual interdependence, 283
North Korea, centrally planned noncollusive, 288–291
economy, 43 overt collusion, 292–293
price, control over, 283
O price leadership model, 295
objective thinking price war, 291
biases, 12–13 pricing, 286–288
causation, 14 product development, 296
causation fallacies, 14 productive efficiency, 298
correlation, 14 research and development, 299
definitions, 13 and technological advance, 299
fallacy of composition, 13 technological advances, 320
loaded terminology, 13 Olson, Mancur, 95
pitfalls, 12–14 opportunity cost
post hoc, ergo propter hoc fallacy, 14 and choice, 4
occupational discrimination, 400 defined, 184
occupational employment trends, economic profit, 186
363 economic rationale, 34
occupational licensing, 388 explicit costs, 184–185
occupational segregation, 404–406 implicit costs, 184–185
occupations, fastest-growing, 363 key concept, 3
offers to purchase, 518–519 law of increasing, 32–34
Old Age Security, 449–450 normal profit, 185–186
oligopoly and tradeoffs, 41
advertising, 296–298 optimal amount of R&D, 312–313
allocative efficiency, 298 Organization of Petroleum
barriers to entry, 283 Exporting Countries (OPEC),
beer industry, 299–300 292–293
complications of “other-things-equal” assumption
interdependence, 288 defined, 8–9
concentration ratio, 284–285 and demand and supply curves,
67
defined, 214, 282 output effect, 361
demand and cost differences, 294 overallocation, 239
differentiated, 283 overproduction, 328
diversity of, 288 overt collusion, 292–293
economies of scale, 283
efficiency, 298–299 P
few large producers, 282–283 packaging, 275
 index 551

partnership, 181, 182 voices of, 452 price floors, 148–149

patents, 248, 305, 317 welfare, 450–451 price leadership
pay for performance “power corrupts,” and individual breakdowns in, 295
bonuses, 398 freedom, 504 communications, 295
commissions, 397 prejudice. See discrimination defined, 295
efficiency wages, 398 price ceilings, 145–149 infrequent price changes, 295
negative side effects, 398–399 price discrimination limit pricing, 295
piece rates, 397 conditions required for, 263 price wars, 295
principal-agent problem, 397 consequences of, 264–266 tactics, 295
profit sharing, 398 defined, 263 price-level stability, 10
royalties, 397 examples of, 263–264 price-maker, 246, 251
stock options, 398 graphical portrayal, 265–266 price supports
payoff matrix, 286 increased profits, 264 bolstering demand, 521
per-unit costs, 194–195 international trade, 264 Canadian Wheat Marketing
percentages, use of, 127–128 market segregation, 263 Board, 518
perfect price discrimination, 264 monopoly power required, 263 criticisms, 522–523
perfectly elastic demand, 129 perfect, 264 crop restriction, 521
perfectly inelastic demand, 129 production, increase in, 264–265 declining political support, 524
personal computers, 329–330 resale, lack of, 263 deficiency payments, 519–521
personal income tax, 495, 500 price elasticity of demand defined, 517
personal savings, as R&D funding, applications of, 136–138 international trade, 524
310 coefficient, 127–128 marketing boards, 517–518
piece rates, 397 decriminalization of illegal drugs, misguided subsidies, 522–523
pink salmon example, 67–68 137–138 offers to purchase, 518–519
planning curve, 201 defined, 127 policy contradictions, 523
plant, 181 determinants of, 135–136 public choice theory, 523–524
plant capacity, 187 extreme cases, 129 surpluses, reduction of, 521
policy economics formula, 127–128 symptoms, not causes, 522
defined, 9 graphical analysis, 131–132 price-taker, 215
economic goals, 10–11 large crop yields and, 137 price war, 291
evaluation, 10 luxuries, 135 prices
formulation of policy, 9–10 midpoint formula, 129–130 changes, and budget line, 173
goal, 9 minimum wage, 138 complementary goods, 55
implementation, 10 minus sign, elimination of, 128 and consumer choice, 160
options, 9 monopolistic competition, 276 of credit, 434
policy issues monopoly, 252–253 economic resources, 59–60
anti-combines policy, 294, 335–336 necessities, 135 expectations, 60
antidiscrimination, 406–408 percentages, use of, 127–128 fair-return, 267–268
farm policy, 516–517 perfectly elastic, 129 foreign exchange, 111–112
global warming, 473–474 perfectly inelastic, 129 government-set. See government-
monopoly, 262 proportion of income, 135 set prices
recycling, 472–473 sales taxes, 137 guiding function of, 84–85
resource market, 353 substitutability, 135 incentive function of, 419
pollution, as spillover cost, 87 summary, 134 independent goods, 55
positive economics, 12 and time, 135–136 and markets, 78–79
positive slope, 21 and total-revenue test, 133–134 in monopolistic competition,
post hoc, ergo propter hoc fallacy, 14 unit elasticity, 128 276–281
Postrel, Virginia, 121 price elasticity of supply monopoly, 253–257, 256–257
poverty defined, 138 new products, 315
absolute, 447 formula, 138 products, 355
defined, 447 long run, 140 rationing function of, 63–65
human suffering and, 452 main determinant of, 138 of related goods, 55–56
invisible poor, 449 market period, 139–140 resource, 360–361
relative, 447 short run, 140 and short-run farm problem,
poor, 447–449 and time, 138 510–513
552 index
socially optimal, 267
strategic barriers to entry, 249
substitute goods, 55
and supply, 58
unrelated goods, 55
principal-agent problem, 184–185,
397
principles
abstractions, 9
defined, 7
exclusion, 89
generalizations, 8
“other-things-equal” assumption,
8–9
terminology, 8
private goods, 89, 457
private property, 76
process innovation, 306, 315–316
producer surplus, 326–327
product demand
changes in, 359–360
elasticity, 364–365
unions, 386
product differentiation
barriers to entry, 278
brand names, 275
defined, 274
location, 275
packaging, 275
price, control over, 275–276
product attributes, 275
service, 275
sufficiency of, 278
tradeoff, 282
product improvements, 315
product innovation, 306, 313–315
product market, 43
product variety, 281–282
product warranties, 478
production
direct methods of, 79
efficient use of resources, 30
full, 30
least cost, 368
overproduction, 328
roundabout, 79
and standard of living, 4
substitution in, 60
underproduction, 328
production costs
average fixed costs, 194
average variable costs, 194–195
constant returns to scale, 203
diseconomies of scale, 203
economies of scale, 201–203
firm size and, 200
fixed costs, 192 plentiful capital, 377
long run, 200–207 real wages, 378
short run, 192–196, 227–229 resource demand, 354–355
total cost, 192–194 technological advances, 377
variable costs, 192 unions, 386
production possibilities curve and wages, 377–378
allocative efficiency, 34–36 products
defined, 32 attributes, 275
and discrimination, 41 average, 188
economic growth, 38 durability, 136
economic rationale, 34 marginal, 188
future possibilities, 39–40 new, 314–315
graphical expression, 33 price, 355
growing economy, 36 standardized, 215
increases in resource supplies, 37 total, 188
and international trade, 40 profit
key graph, 33 calculations, 222
law of increasing opportunity economic. See economic profit
cost, 32–34 monopolistic competition,
opportunity cost, 41 277–278
present choices, 39–40 in monopoly, 256
productive inefficiency, 36, 40–41 normal, 185–186, 219, 430
shape of, 34 and price discrimination, 264
shifts in, 41–42 sharing, 398
technological advances, 38–39 unit, 256
tradeoffs, 41 profit maximization
unemployment, 36, 40–41 in long run, 231–237
production possibilities table long-run equilibrium, 232–234
assumptions, 30–31 loss-minimizing case, 224–225
choice, need for, 31–32 marginal-revenue-marginal-cost
defined, 31 approach, 220–222
law of increasing opportunity in monopoly, 253
cost, 32–34 MR=MC rule, 221
understanding of choices, 30 resource demand, 369
productive efficiency short run, 218–224
defined, 30 shutdown case, 225–226
monopolistic competition, total-revenue-total-cost approach,
280–281 218–219
monopoly, 257 profit-maximizing combination of
oligopoly, 298 resources, 367
pure competition, 237 Progress and Poverty (George), 420
pure monopoly, 257 progressive tax, 494, 495
technological advances, 322 property
productive inefficiency crimes, 169
graphical expression, 36 rights, 76
production possibilities curve, taxes, 495, 502
40–41 proportion of income, 135
and unemployment, 36, 40–41 proportional tax, 494
productivity protectionism, 116
abundant natural resources, protective tariffs, 114–115
access to, 377 public choice theory
changes in, 360 defined, 484
and economic rent, 421 inefficient “no” vote, 484
intangible factors, 378 inefficient voting outcomes,
labour quality, 378 484–486
marginal revenue, 393 inefficient “yes” vote, 485

interest groups, 486
logrolling, 486
median-voter model, 487–489
price supports, 523–524
voting, paradox of, 486–487
public goods
cost-benefit analysis, 460–461
defined, 89
demand, 457–458
exclusion principal, 457
highway construction, 460–461
indivisibility, 457
MC=MB rule, 461
optimal quantity, 459
recycling, 470–473
solid-waste disposal, 470–473
spillover benefits, extremely
large, 466
supply, 458–459
public interest in theory of
regulation, 340–341
public ownership, 340
public sector, and circular flow
model, 91–92
pure competition
allocative efficiency, 237, 239,
257–258
average revenue, 216
average total costs, 237
break-even point, 219
characteristics, 214–215
constant-cost industry, 234–235
consumer surplus, 241
decreasing-cost industry, 236–237
defined, 214
and demand, 216–217
diminishing returns, 227–229
dynamic adjustments, 240
and efficiency, 237–240
efficient allocation, 240
free entry and exit, 215
graphical portrayal, 217
increasing-cost industry, 235–236
individual firms, demand
schedule of, 216
large numbers, 214
long-run supply curve, 234–235
loss-minimizing case, 224–225
marginal costs, 226–231
marginal revenue, 217
marginal-revenue-marginal-cost
approach, 220–222
MR=MC rule, 221
occurrence of, 214–215
overallocation, 239
perfectly elastic demand, 216
P=MC rule, 228
price-taker, 215
product supply, 227–229
production costs, 227–229
productive efficiency, 237
profit-maximization in short run,
218–224
relevance of, 216
short-run profit-maximization,
key graphs, 223
short-run supply, 226–231
short-run supply curve, 227
shutdown case, 225–226
standardized product, 215
supply curve shifts, 229
technological advances, 319
total revenue, 217
total-revenue-total-cost approach,
218–219
underallocation, 239
pure monopoly
see also monopoly
blocked entry, 246
characteristics, 246
defined, 214, 246
economic effects, 257–262
efficiency outcome, 257–259
examples of, 246
key graph, 254
output outcome, 257–259
price-maker, 246
price outcome, 257–259
productive efficiency, 257
single seller, 246
substitutes, lack of close, 246
supply curve, lack of, 255–256
technological advances, 320
pure rate of interest, 426
purely competitive labour market,
379–382
Q personal savings as funding, 310
quasi-public goods, 89–90
quotas, and imports, 115
R 310
randomness, 121
rate regulation, 266
rational behavior, 160
rational self-interest, 5
rationing function of prices, 63–64
rationing problem, 146
rationing system, 149–150
real capital, 28
real interest rate, 427
real wages, 376, 378–379
index 553
recessions, 142, 294
reciprocal trade agreements, 117
recycling, 470–473
regressive tax, 494, 495
regulated monopoly, 266–268
regulatory agencies, 336
relative poverty, 447
relative scarcity, 29
relatively elastic product, 127
relatively inelastic product, 129
remittances, 410–411
rent. See economic rent
rent controls, 147–148
rent-seeking behaviour, 261, 490
rental income, 29
research and development
see also innovation; technological
advances
affordable, 312
bank loans for, 310
barrier to entry, 248
bonds as funding, 310
expected rate of return, 311, 312
expenditures, 306
fast-second strategy, 317
financing, 310
government scientific research,
309
imitation, problem of, 316–318
incentives, 316–318
and interest, 427
interest-rate cost-of-funds curve,
310
in monopoly, 261–262
in oligopoly, 299
optimal amount of, for firms,
309–313
optimal amount of R&D, 312–313
optimal industry structure,
321–322
patents, 317
retained earnings as funding,
310
spending decision, complexity of,
time lags, 317–318
trade secrets, 317
university scientific research, 309
venture capital as funding, 310
resource demand
complementary resources,
361–362
derived demand, 353–354
determinants of, 359–363
elasticity, 363–365
554 index

elasticity of product demand, average, 216 defined, 510

364–365 marginal, 217, 250–251 demand fluctuations, 511–513
and imperfect product market schedule, 216 income instability, 510–513
competition, 356–359 to supplier, 58 inelastic demand, 510
labour demand, changes in, 363 supply, 58 output fluctuations, 510–511
least cost production, 368 tax, 498 price and, 510–513
marginal product, decline in, 364 total, 132, 186, 217 short-run supply curve, 227
marginal revenue product, reverse discrimination, 408 shortages
354–355 Ricardo, David, 108 defined, 62
MRP=MRC rule, 356 risk human organs, 150–151
output effect, 361 bearer, 29 price ceilings, 145–149
prices of other resources, changes global warming, 473 simultaneous consumption, 259
in, 360–361 income inequality, 441–442 Singapore, 104
product demand, changes in, insurable, 430 single seller, 246
359–360 and interest, 425 single-tax movement, 421, 505–506
productivity, 354–355, 360 uninsurable, 430–431 single tax on land, 420–421
profit maximization, 369 roundabout production, 79 slope
quantities of other resources, 360 royalties, 397 infinite, 22
resource cost to total cost, ratio of, Russia and marginal analysis, 21–22
365 market-oriented system in, 43 and measurement units, 21
schedule, 356 market reforms, 105–106 negative, 21
substitute resources, 361 nonlinear curve, 23
substitution, ease of, 364 S positive, 21
substitution effect, 361 sales taxes, 137, 495, 501–502 of straight line, 21
technological advances, 360 scalping, 69 zero, 22
variable resource, quality of, 360 scarcity Smith, Adam, 86, 108, 167
resources defined, 4 social regulation
allocation, 353 relative, 29 and competition, 346
complementary, 361–362 resources, 28 criticisms of, 346
cost, 365 Schumpeter, Joseph, 323–324 defined, 344
demand for. See resource demand scientific method features of, 344
economic profit, and allocation of, defined, 6 free lunch, 346
432 theories, 6–7 innovation, impact on, 346
essential, ownership or control of, self-interest less government, issue of, 346–347
249 in market system, 77–78 optimal level of, 344–345
flows, 100 rational, 5 product prices, increases in, 346
least-cost rule, 366 selfishness, vs. rational self-interest, support for, 345
marginal productivity, 360 5 socialism, 42–43
market, 43 sellers, number of, 60 socially optimal price, 267
market demand for, 359 service sole proprietorship, 181, 182
money not, 422 flows, 100 solid-waste disposal, 470–473
natural, 377 and product differentiation, 275 Sony, 107
optimal combination, 365–369 short run South Korea
overallocation, 520 defined, 140, 187 new participant in international
payments, 29 law of diminishing returns, trade, 104
price, changes in, 360–361 227–229 production possibilities curve, 40
pricing, 353 monopolistic competition, 276 Soviet Union, 43
profit-maximizing combination of price elasticity of supply, 140 special-interest effect, 489–490, 492
resources, 367 product supply, 227–229 specialization
rule for employment of, 355–356 production costs, 192–196, and comparative advantage,
substitute, 361 227–229 108–111
variable, quality of, 360 production relationships, 188–190 defined, 79–80
Restrictive Trade Practices profit-maximization, 218–224 differences in ability, 80
Commission, 338 supply, 226–231 gains from, 110–111
retained earnings, 310 short-run adjustments, 187 gains from trade, 110–111
revenue short-run farm problem geographic, 80

human, 80
and international trade, 108–111
key concept, 3
learning by doing, 80
and market system, 79–80
and resource allocation, 111
time savings, 80
spillover benefits
auto antitheft device, 479–480
consumers, subsidizing, 88
correcting for, 88–89
defined, 88
education, 88
goods via government, 89
immunization, 88
and resource allocation, 462
and subsidies, 465–466
supply, subsidizing, 89
spillover costs
correcting for, 88
cost curves, shifts in, 470
defined, 87
direct controls, 464
and equilibrium quantity, 469–470
externality rights, market for, 467
and legislation, 88
market-based approach, 466–474
market operation, 467–468
optimal amount of externality
reduction, 468–470
pollution, 87
and resource allocation, 462
specific taxes, 464–465
and taxes, 88
tragedy of the commons, 466–467
standard of living, as key concept, 4
start-ups, 308
static economy, 430
statistical discrimination, 403–404
stock market crashes, and graphs,
20
stock options, 398
stocks, 183
strategic barriers to entry, 249
subsidies
to buyers, 465
exports and, 115
farm, 516–517
government provision, 466
misguided, 522–523
to producers, 465
and spillover benefits, 465–466
and supply, 60
substitutability, 135
substitute goods, 55, 141
substitute resources, 361
index 555
substitutes, lack of close, 246 shifts in, and pure competition,
substitution 229
in consumption, 55 short-run, 227
effect, 51–52, 156, 165–166, 361 upsloping, 140
marginal rate of, 175 surgeons, licensing of, 475–476
in production, 60 surplus
sunk costs, 208–209 consumer, 325–326
supply consumer, and pure competition,
change in, 59–60, 61 241
change in, and equilibrium, 65 defined, 62
change in quantity supplied, 61 land rent, 419–420
decrease, and demand decrease, and offers to purchase, 518–519
66–67 and price floors, 148–149
decrease, and demand increase, producer, 326–327
65 reduction of, and agriculture, 521
decrease in, 59 trade, 103
defined, 57 symphony orchestras, 412
and derived demand, 83
determinants of, 58–59 T
economic resources, prices of, tacit understandings, 293
59–60 Taiwan, 104
increase, and demand decrease, tariffs
65 defined, 104
increase, and demand increase, general decline in, 104
66 protective, 114–115
increase in, 59 taste-for-discrimination model,
and interest, 424 400–401
labour, 381 tastes, 54
law of, 58 tax incidence
loanable funds, 423 corporate income tax, 500–501
and long-run farm problem, defined, 496
513–514 division of burden, 496–497
marginal costs in short-run, efficiency loss of a tax, 498–500
226–231 elasticity, 143–145, 497–498
other goods, prices of, 60 excise taxes, 501–502
pink salmon example, 67–68 personal income tax, 500
price elasticity of. See price probable, in Canada, 500–502
elasticity of supply property taxes, 502
price expectations, 60 sales taxes, 501–502
and prices, 58 tax reforms, 502–503
public goods, 458–459 tax revenues, 498
recyclables, incentive for, 472–473 taxation
revenue, 58 ability-to-pay principle, 493–494
schedule, 57 apportionment of burden,
sellers, number of, 60 493–495
shifters, 59 benefits-received principle, 493
short run, 226–231 corporate income tax, 495
and subsidies, 60 and demand, 143–144
subsidize, 89 division of burden, 143–144
and taxes, 60 efficiency loss of a tax, 498–500
and technological advances, 60 and elasticity, 143–145
supply curve Goods and Services Tax, 502
defined, 58 personal income tax, 495
long-run, 234–235 progressive tax, 494, 495
in monopoly, 255–256 property taxes, 495
in pure monopoly, 255–256 proportional tax, 494
556 index
reforms, 502–503
regressive tax, 494, 495
sales taxes, 495
single-tax movement, 421,
505–506
and spillover costs, 88, 464–465
and supply, 60
technological advances
see also research and development
allocative efficiency, 322–323
and anti-combines legislation,
339–340
communications, 104
creative destruction, 323–324
defined, 305
diffusion, 306
efficiency, 322–324
flows, 100
future, anticipation of, 308–309
innovation, 305–306
innovators, 308
Internet, 329–330
invention, 305
inverted-U theory, 321–322
long-run farm problem, 513–514
market structure and, 319–322
in market system, 79, 85
modern view of, 306–307
monopolistic competition,
319–320
and monopoly, 261–262
oligopoly, 299, 320
patents, 305
personal computers, 329–330
process innovation, 306
product innovation, 306
and production possibilities
curve, 38–39
productive efficiency, 322
productivity, 377
pure competition, 319
pure monopoly, 320
research and development
expenditures, 306
resource demand, 360
and supply, 60
transportation, 103–104
very long run, 305
terminology, 8
terminology, loaded, 13
terms of trade, 109–110
theoretical economics, 7
theories
abstractions, 9
defined, 6–7
inverted-U theory, 321–322 misunderstanding of gains from
kinked-demand theory. See trade, 115
kinked-demand theory non-tariff barriers, 115
legal cartel theory of regulation, political considerations, 116
342 protective tariffs, 114–115
loanable funds theory of interest, purpose of, 115–116
422–423 trade bloc
marginal productivity theory of defined, 118
income distribution, 369–370 EU, 118–119
public choice. See public choice trademarks, 317
theory tradeoffs
ticket scalping, 69 anti-combines enforcement,
time 339–340
and income inequality, 440 defined, 10
input substitution process, 364 equality-efficiency trade-off,
lags, 317–318 446–447
and price elasticity, 135–136, 138 and government-set prices,
value of, and consumer choice, 149–150
167–168 key concept, 3
Toronto Stock Exchange, 50 and opportunity costs, 41
total cost, 192–194, 365 product differentiation, 282
total product, 188 tragedy of the commons, 466–467
total revenue, 132, 186, 217 transition costs of global warming,
total-revenue test 474
defined, 132 transportation technology, 103–104
elastic demand, 132–133 Turner, Ted, 78
inelastic demand, 133
monopoly, 252–253 U
and price elasticity, 133–134 underallocation, 239
unit elasticity, 133 underproduction, 328
total utility, 157 unemployment
trade effect of unions, 389–390
deficit, 103 vs. full employment, 411
flows, 100 graphical expression, 36
gains from, 110–111 production possibilities curve,
key concept, 3 40–41
patterns, 101, 103 and productive inefficiency, 36
secrets, 317 Unilever, 104
surplus, 103 uninsurable risk, 430–431
terms of, 109–110 unions
trade agreements bilateral monopoly, 390–391
General Agreement on Tariffs and craft union model, 387–388
Trade (GATT), 117–118 decline in, and income inequality,
most-favoured-nation clauses, 444
117 demand-enhancement model,
North American Free Trade 385–387
Agreement (NAFTA), elasticity, effect on, 389–390
119–120 exclusive unionism, 387–388
reciprocal, 117 growth, effect on, 389
World Trade Organization (WTO), inclusive unionism, 388–389
118 industrial union model, 388–389
trade barriers input prices, increases, 386–387
costs, 116 productivity, increase, 386
export subsidies, 115 products demand, increase, 386
import quotas, 115 unemployment effect, 389–390

wage differentials, 396
wages, 389–390
unit elasticity, 128, 133
United States
recession in, 107
as trading partner, 103
university scientific research, 309
unlimited wants, 27–28
unrelated goods, 55
unsuccessful new products, 315
Uruguay Round, 117–118
usury laws, 428–429
utility
defined, 27, 157
marginal. See marginal utility
maximization, and demand
curve, 164–166
measurement of, 177
utility-maximizing rule, 160–161
V defined, 29
variable costs, 192
venture capital, 310
Verson stamping machine, 206
vertical axis, 18
vertical intercept, 22
vertical merger, 336
very long run, 305
visible minority-white wage ratio,
402–403
visible-minority workers,
402–403
voting
consumer dollar votes, 83
hypothetical example, 487
inefficient outcomes, 484–486
median-voter model, 487–489
paradox, 486–487
preferences, 486–487
“with their feet,” 489
W conventions and customs, 27
wage differentials
and ability, 394–395
compensating differences, 395
defined, 393
discrimination, 396
education, 395
geographic immobility, 396
government restraints, 396
investment in human capital, 395
job information, lack of, 396
marginal revenue productivity,
393
market imperfections, 395
noncompeting groups, 393–394
training, 395
unions and, 396
wage discrimination, 399
wages
above-equilibrium, 398
efficiency, 398
equilibrium, in monopsony, 384
general level, 376–379
and immigration, 408–409
male, slower growth of, 46
minimum, 391–392
in monopsony, 383–384
nominal, 376
pay for performance, 397–399
productivity, 378
real, 376, 378–379
secular growth, 379
unions, 389–390
visible minority-white wage ratio,
402–403
women and, 45
wants
biological roots, 27
coincidence of, 81
index 557
unlimited, 27–28
water, marginal utility of, 167
wealth, unequal distribution of,
442
Wealth of Nations (Smith), 86
welfare
benefit-reduction rate, 450
common features, 450–451
conflict among goals, 451
Western Europe, and international
trade, 104
willingness to purchase, 156
women
antidiscrimination policies, 407
changing preferences and
attitudes, 45
declining birthrates, 45
divorce rates, 46
expanded job access, 45
expanded production
possibilities, 45–46
male wages, slower growth of,
46
rising wage rates, 45
workplace safety, and asymmetric
information, 477–478
World Trade Organization (WTO),
118
X
X-inefficiency, 260–261
Y
yen-dollar market, 112
Yugoslavia, and production
possibilities curve, 42
Z
zero slope, 22